Return on Average Capital Employed – ROACE

What Is Return on Average Capital Employed – ROACE?

The return on average capital employed (ROACE) is a financial ratio that shows profitability versus the investments a company has made in itself. This metric differs from the related return on capital employed (ROCE) calculation, in that it takes the averages of the opening and closing capital for a period of time, as opposed to only the capital figure at the end of the period.

The Formula for ROACE Is

ROACE = EBIT Average Total Assets − L where: EBIT = Earnings before interest and taxes L = Average current liabilities \begin{aligned} &\text{ROACE} = \frac{ \text{EBIT} }{ \text{Average Total Assets} - \text{L} } \\ &\textbf{where:} \\ &\text{EBIT} = \text{Earnings before interest and taxes} \\ &\text{L} = \text{Average current liabilities} \\ \end{aligned} ROACE=Average Total Assets−LEBITwhere:EBIT=Earnings before interest and taxesL=Average current liabilities

What Does Return on Average Capital Employed Tell You?

Return on average capital employed (ROACE) is a useful ratio when analyzing businesses in capital-intensive industries, such as oil. Businesses that can squeeze higher profits from a smaller amount of capital assets will have a higher ROACE than businesses that are not as efficient in converting capital into profit. The formula for the ratio uses EBIT in the numerator and divides that by average total assets less average current liabilities.

Fundamental analysts and investors like to use the ROACE metrics since it compares the company's profitability to the total investments made in new capital.

Example of How ROACE Is Used

As a hypothetical example of how to calculate ROACE, assume that a company begins the year with $500,000 is assets and $200,000 in liabilities. It ends the year with $550,000 in assets and the same $200,000 in liabilities. During the course of the year, the company earned $150,000 of revenue and had $90,000 of total operating expenses. Step one is to calculate the EBIT:

EBIT = R − O = $ 1 5 0 , 0 0 0 − $ 9 0 , 0 0 0 = $ 6 0 , 0 0 0 where: R = Revenue O = Operating expenses \begin{aligned} &\text{EBIT} = \text{R} - \text{O} = \$150,000 - \$90,000 = \$60,000 \\ &\textbf{where:} \\ &\text{R} = \text{Revenue} \\ &\text{O} = \text{Operating expenses} \\ \end{aligned} EBIT=R−O=$150,000−$90,000=$60,000where:R=RevenueO=Operating expenses

The second step is to calculate the average capital employed. This is equal to the average of the total assets minus the liabilities at the beginning of the year and the end of the year:

CB = $ 5 0 0 , 0 0 0 − $ 2 0 0 , 0 0 0 = $ 3 0 0 , 0 0 0 where: CB = Capital employed beginning of year \begin{aligned} &\text{CB} = \$500,000 - \$200,000 = \$300,000 \\ &\textbf{where:} \\ &\text{CB} = \text{Capital employed beginning of year} \\ \end{aligned} CB=$500,000−$200,000=$300,000where:CB=Capital employed beginning of year

CE = $ 5 5 0 , 0 0 0 − $ 2 0 0 , 0 0 0 = $ 3 5 0 , 0 0 0 where: CE = Capital employed end of year \begin{aligned} &\text{CE} = \$550,000 - \$200,000 = \$350,000 \\ &\textbf{where:} \\ &\text{CE} = \text{Capital employed end of year} \\ \end{aligned} CE=$550,000−$200,000=$350,000where:CE=Capital employed end of year

AC = $ 3 0 0 , 0 0 0 + $ 3 5 0 , 0 0 0 2 = $ 3 2 5 , 0 0 0 where: AC = Average capital employed \begin{aligned} &\text{AC} = \frac{ \$300,000 + \$350,000 }{ 2 } = \$325,000 \\ &\textbf{where:} \\ &\text{AC} = \text{Average capital employed} \\ \end{aligned} AC=2$300,000+$350,000=$325,000where:AC=Average capital employed

Lastly, by dividing the EBIT by the average capital employed, the ROACE is determined:

ROACE = $ 6 0 , 0 0 0 $ 3 2 5 , 0 0 0 = 1 8 . 4 6 % \begin{aligned} &\text{ROACE} = \frac{ \$60,000 }{ \$325,000 } = 18.46\% \\ \end{aligned} ROACE=$325,000$60,000=18.46%

The Difference Between ROACE and ROCE

Return on capital employed (ROCE) is a closely-related financial ratio that also measures a company's profitability and the efficiency with which its capital is employed. ROCE is calculated as follows:

ROCE = EBIT Capital Employed \begin{aligned} &\text{ROCE} = \frac{ \text{EBIT} }{ \text{Capital Employed} } \\ \end{aligned} ROCE=Capital EmployedEBIT

Capital employed, also known as funds employed, is the total amount of capital used for the acquisition of profits by a firm or project. It is the value of all the assets employed in a business or business unit and can be calculated by subtracting current liabilities from total assets. ROACE, on the other hand, uses average assets and liabilities. Averaging for a period smooths the figures to remove the effect of outlier situations, such as seasonal spikes or declines in business activity.

Limitations of ROACE

Investors should be careful when using the ratio, since capital assets, such as a refinery, can be depreciated over time. If the same amount of profit is made from an asset each period, the asset depreciating will make ROACE increase because it is less valuable. This makes it look as if the company is making good use of capital, though, in reality, it is not making any additional investments.