Key Takeaways
- Measures profitability using EBIT over average capital.
- Averages opening and closing capital for accuracy.
- Shows efficient use of long-term invested funds.
What is Return on Average Capital Employed (ROACE)?
Return on Average Capital Employed (ROACE) measures a company's operating profitability by dividing earnings before interest and taxes (EBIT) by the average capital employed over a period. This approach provides a more accurate assessment of capital efficiency than using a single point-in-time figure.
ROACE helps investors and executives in the C-suite evaluate how well a company utilizes its long-term funds to generate profits before financing costs.
Key Characteristics
ROACE offers several important features that make it valuable for financial analysis:
- Averaging Capital Employed: Uses the average of beginning and ending capital employed, reducing distortions from fluctuations in asset levels.
- Focus on Operating Profit: Employs EBIT, excluding interest and tax expenses, to reflect core business performance.
- Capital Employed Definition: Calculated as total assets minus current liabilities or shareholders' equity plus non-current liabilities, emphasizing long-term capital.
- Useful in Capital-Intensive Sectors: Particularly relevant for industries requiring significant paid-up capital, such as energy and manufacturing.
- Comparison Across Companies: Enables benchmarking of operational efficiency against peers and industry standards.
How It Works
To calculate ROACE, you first determine EBIT from the income statement, representing earnings from core operations before interest and taxes. Next, compute capital employed at the start and end of the period from the balance sheet.
Then, average the two capital employed figures to smooth out seasonal or timing effects. Finally, divide EBIT by this average and express the result as a percentage to assess profitability relative to the resources invested.
Examples and Use Cases
ROACE is widely used to analyze companies where capital efficiency is critical for shareholder value.
- Energy Sector: Chevron and ExxonMobil use ROACE to evaluate returns on their large-scale investments in exploration and infrastructure.
- Stock Selection: Investors seeking stable returns may consult lists of best energy stocks to identify companies with strong ROACE metrics.
- Market Capitalization Focus: Comparing ROACE among best large-cap stocks helps investors assess operational success in established companies.
Important Considerations
While ROACE offers valuable insights, it should be interpreted with caution. Differences in accounting policies and capital structures can affect comparability. ROACE does not consider cash flow timing or tax effects, unlike some other metrics.
Also, industries with rapid ramp-up phases may show volatile ROACE figures, so assessing trends over multiple periods is advisable for better decision-making.
Final Words
ROACE provides a clearer picture of how efficiently a company uses its capital to generate profits over time. To apply this metric effectively, compare ROACE across similar firms or time periods to identify true operational performance.
Frequently Asked Questions
ROACE measures a company's profitability by dividing earnings before interest and taxes (EBIT) by the average capital employed during a period. It provides a more accurate view of capital efficiency by averaging the opening and closing capital balances.
To calculate ROACE, first find EBIT from the income statement, then calculate the average capital employed by averaging the beginning and ending capital employed from the balance sheet. Finally, divide EBIT by this average and multiply by 100 to get a percentage.
ROACE is preferred over standard ROCE because it uses the average capital employed over the period rather than a single point-in-time figure. This averaging offers a more accurate reflection of capital utilization, especially in capital-intensive industries.
A strong ROACE indicates effective use of equity, debt, and other long-term funds to generate operating profits before financing costs. Ideally, ROACE should exceed the company's weighted average cost of capital (WACC) and be higher than peers to show value creation.
Capital employed can be calculated as total assets minus current liabilities or as shareholders' equity plus non-current liabilities. The latter method is preferred because it focuses on long-term investments relevant for measuring ROACE.
EBIT represents earnings before interest and taxes, reflecting operating profit from core business activities. Using EBIT in ROACE highlights operational efficiency before financing and tax effects.
Yes, ROACE helps investors compare how efficiently different companies generate returns from their invested capital by providing a standardized measure of operating profitability relative to average capital employed.
ROACE is especially useful in capital-intensive industries where large investments in assets and long-term funds are common. It helps assess how well companies in these sectors utilize their capital to generate operating profits.
