Return on Average Capital Employed (ROACE): Definition, Calculation, and Applications

Return on Average Capital Employed (ROACE) is a financial ratio that assesses a company’s profitability relative to the investments it has made in itself. This metric is particularly relevant in capital-intensive industries such as oil, where efficient use of capital is paramount for success. Unlike the related metric Return on Capital Employed (ROCE), ROACE takes into account the averages of opening and closing capital over a defined period, providing a more comprehensive view of a company’s performance.

The formula for calculating ROACE is:

ROACE = EBIT / (Average Total Assets – Average Current Liabilities)

Where:
– EBIT stands for Earnings Before Interest and Taxes.
– Average Total Assets represent the mean value of assets over a period.
– Average Current Liabilities denote the average amount of liabilities during the same period.

Return on Average Capital Employed (ROACE) offers valuable insights into how efficiently a company utilizes its capital to generate profits. It serves as a key metric for fundamental analysts and investors, providing a measure of a company’s profitability relative to the total investments made in new capital. Businesses with higher ROACE ratios are deemed more effective in converting capital assets into profits compared to those with lower ratios.

To illustrate the calculation of ROACE, let’s consider a hypothetical scenario:
– Beginning of the year: Assets = $500,000, Liabilities = $200,000
– End of the year: Assets = $550,000, Liabilities = $200,000
– Revenue earned during the year = $150,000, Operating expenses = $90,000

1.Calculate EBIT:
EBIT = Revenue – Operating expenses
= $150,000 – $90,000
= $60,000

2.Determine Average Capital Employed:
– Beginning of the year: $500,000 – $200,000 = $300,000
– End of the year: $550,000 – $200,000 = $350,000
– Average Capital Employed = ($300,000 + $350,000) / 2 = $325,000

3. Compute ROACE:
ROACE = EBIT / Average Capital Employed
= $60,000 / $325,000
≈ 18.46%

While ROACE and Return on Capital Employed (ROCE) both assess a company’s profitability and capital efficiency, they differ in their calculation methods. ROCE considers capital employed at a specific point in time, while ROACE accounts for the average of assets and liabilities over a period. This averaging helps smooth out fluctuations in business activity, providing a more stable measure of performance.

Investors should be cautious when interpreting ROACE, as it may be influenced by factors such as asset depreciation over time. Additionally, ROACE can be inflated if a company generates consistent profits from depreciating assets, making it appear more efficient in utilizing capital than it actually is. Therefore, it’s essential to consider additional financial metrics and qualitative factors when evaluating a company’s performance.

ROACE considers the average of assets and liabilities over a period, providing a smoothed-out measure of a company’s performance. In contrast, ROCE evaluates capital employed at a specific point in time, which may be subject to fluctuations due to seasonal or cyclical factors.

ROACE offers investors a comprehensive view of a company’s profitability relative to its capital investments over time. By considering the averages of assets and liabilities, ROACE provides a more stable measure of performance, helping investors assess the efficiency of capital utilization and make informed investment decisions.

To improve ROACE, a company can focus on increasing profitability while efficiently managing its capital assets and liabilities. This may involve optimizing operational processes, reducing expenses, and making strategic investments that generate higher returns. Additionally, effectively managing working capital and minimizing debt can contribute to improved ROACE over time.

While ROACE is a valuable metric for assessing a company’s performance, it has limitations that investors should be aware of. One limitation is that ROACE may be influenced by factors such as asset depreciation and fluctuations in business activity. Additionally, ROACE should be used in conjunction with other financial metrics and qualitative analysis to gain a comprehensive understanding of a company’s financial health and prospects.