What Is Return on Average Capital Employed – ROACE?

What Is Return on Average Capital Employed – ROACE?

Let me explain what return on average capital employed, or ROACE, really is. It's a financial ratio that reveals how profitable a company is compared to the investments it's made in its own operations. You should know that this differs from the similar return on capital employed (ROCE) because ROACE uses the averages of the opening and closing capital over a time period, not just the end-of-period figure.

The Formula for ROACE

Here's the straightforward formula for ROACE: it's EBIT divided by average total assets minus average current liabilities. In this, EBIT stands for earnings before interest and taxes, and L represents average current liabilities. You calculate it as ROACE = EBIT / (Average Total Assets - L).

What Does Return on Average Capital Employed Tell You?

ROACE is particularly helpful when you're looking at businesses in capital-intensive sectors, like the oil industry. If a company can generate higher profits from less capital assets, it'll show a higher ROACE than one that's less efficient at turning capital into profit. The formula takes EBIT in the numerator and divides it by average total assets minus average current liabilities.

As a fundamental analyst or investor, you'll find ROACE useful because it directly compares the company's profitability to the total investments in new capital. It gives you a clear picture of efficiency in using those investments.

Example of How ROACE Is Used

Let's walk through a hypothetical example to see ROACE in action. Suppose a company starts the year with $500,000 in assets and $200,000 in liabilities, and ends with $550,000 in assets and the same $200,000 in liabilities. Over the year, it earns $150,000 in revenue and has $90,000 in total operating expenses.

First, calculate EBIT: that's revenue minus operating expenses, so $150,000 - $90,000 = $60,000.

Next, find the average capital employed. Capital employed at the beginning is $500,000 - $200,000 = $300,000. At the end, it's $550,000 - $200,000 = $350,000. The average is ($300,000 + $350,000) / 2 = $325,000.

Finally, ROACE is $60,000 / $325,000 = 18.46%. This shows you how the ratio comes together step by step.

The Difference Between ROACE and ROCE

You need to understand how ROACE differs from ROCE, which is a related ratio measuring profitability and capital efficiency. ROCE is calculated as EBIT divided by capital employed, where capital employed is total assets minus current liabilities at a specific point, usually the end of the period.

In contrast, ROACE uses averages of assets and liabilities over the period, which smooths out the numbers and eliminates the impact of unusual spikes or drops in activity, like seasonal variations. This makes ROACE a more balanced view in many cases.

Limitations of ROACE

Be cautious when using ROACE, as it has its drawbacks. For instance, capital assets like a refinery depreciate over time. If a company makes the same profit each period from a depreciating asset, ROACE will appear to increase because the asset's value drops, suggesting better capital use—even though no new investments are being made. This can mislead you about the company's actual efficiency.