What Is Return on Average Capital Employed (ROACE)?
Return on Average Capital Employed (ROACE) is a financial ratio that shows a company’s profitability in relation to the investments it has made in itself. This metric is particularly useful for analyzing businesses in capital-intensive industries. Unlike the Return on Capital Employed (ROCE) calculation, ROACE takes averages of opening and closing capital for a specified period, yielding a more dynamic insight into capital usage.
The ROACE Formula
The formula for ROACE is:
[ \text{ROACE} = \frac{\text{EBIT}}{\text{Average Total Assets} - \text{Average Current Liabilities}} ]
Where:
- EBIT: Earnings before interest and taxes
- Average Total Assets: The mean total assets over the given period
- Average Current Liabilities: The mean current liabilities over the given period
Interpreting ROACE
ROACE is especially indicative when evaluating companies in fields where large capital investments are typical, such as the oil industry. Businesses that generate higher profits from a smaller amount of capital assets will present a higher ROACE, highlighting efficient capital utilization.
Importance for Analysts and Investors
Fundamental analysts and investors favor ROACE because it compares a company’s profitability to the total investments in new capital:
- Indicative of profitability relative to capital investments
- Favored by fundamental analysts and investors
Example Calculation of ROACE
To calculate ROACE, let’s assume a company starts the year with $500,000 in assets and $200,000 in liabilities and ends the year with $550,000 in assets and the same liabilities. Over the year, the company earns $150,000 in revenue and incurs $90,000 in operating expenses.
- Calculate EBIT:
[ EBIT = R - O = $150,000 - $90,000 = $60,000 ]
- Calculate Average Capital Employed:
Beginning of Year:
[ \text{CB} = $500,000 - $200,000 = $300,000 ]
End of Year:
[ \text{CE} = $550,000 - $200,000 = $350,000 ]
Average:
[ \text{AC} = \frac{$300,000 + $350,000}{2} = $325,000 ]
- Calculate ROACE:
[ \text{ROACE} = \frac{$60,000}{$325,000} = 18.46% ]
ROACE vs. ROCE
Return on Capital Employed (ROCE) and ROACE both measure a company’s profitability relative to its capital; however, ROCE uses total assets at the end of the period and does not average the values over time.
ROCE Formula:
[ \text{ROCE} = \frac{\text{EBIT}}{\text{Capital Employed}} ]
Limitations of ROACE
While ROACE is a beneficial metric, investors should be cautious about certain limitations. For instance, capital assets like a refinery depreciate over time. Consistently making the same amount of profit while the value of capital assets falls will inflate ROACE artificially, giving a false perception of efficient capital usage.
Related Terms: Return on Capital Employed (ROCE), Earnings Before Interest and Taxes (EBIT), current liabilities, capital assets.
