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Ever wondered why PAT is not used in ROCE calculations or NOPAT is not used in ROE calculations?



The answer lies in the consistency of the corporate finance theory.


ROCE (Return on capital employed) looks at the overall returns for all the investors of the company and is derived by


ROCE = EBIT(1-T)/(Avg. Debt + Avg. Equity)


where the denominator represents the total capital employed in a firm from all sources i.e. debt and equity


We cannot have PAT sitting on the numerator of the above equation as PAT is a residual line item left after making interest payments and hence is relevant for equity investors.


However, EBIT is a line item left after the firm has taken care of basic expenses required for producing and selling the inventory (or services) and before you have made payments to your debt holders and hence represents a profit which is relevant for both set of investors.


Needless to say tax is a mandatory expense hence it makes sense to look at NOPAT then an EBIT.


The same principle holds true when you look at ROE calculations.


ROE = PAT/Avg. Equity


Here we use PAT instead of NOPAT as ROE concerns the returns relevant to equity investors only.


The beauty of a law or principle lies in its enduring consistency across multiple scenarios. Corporate Finance theory is one such law that remains strong across multiple situations.


Thanks,

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