Return on Average Capital Employed (ROACE)
Meaning and definition of Return on Average Capital Employed
The return on average capital employed (ROACE) is a ratio that reveals the profitability against the investments made in the company. The ROACE is different from the return on capital employed for it counts the average of the opening and closing capital for the specific period contrasting to only the capital figure at the end of a period.
As stated by Investopedia, the return on average capital employed is helpful for analyzing businesses in capital-intensive industries, oil for example. The businesses capable of squeezing higher profits from a smaller amount of capital assets will feature a higher ROACE as compared to those which are not efficient in transforming capital into profits.
Formula used for computing return on average capital employed
The ROACE is calculated as:
ROACE = EBIT / (Average Total Assets - Average Current Liabilities)
i.e. Capital Employed = Total Assets – Current Liabilities = Equity + Non-current Liabilities
Calculating Return on Average Capital Employed
The key steps involved in calculating the Return on Average Capital Employed include:
1. Deduct the operating expenses from the revenue to obtain the company’s earnings before interest or tax (EBIT).
2. Deduct the value of liabilities from the value of total assets to obtain capital employed at the begging of the period plus at the end of the period and divide it by 2.
3. Divide the EBIT by the result obtained as capital employed to obtain the ROACE.
Example for Return on Average Capital Employed
The calculation of Return on Average Capital Employed can be illustrated in the following example:
Let us suppose a company with assets worth $10,000 at the begging of the period and $12,000 at the end of period; liabilities worth $2,000 at the begging of the period and $3,000 at the end of period; revenue for the period worth $5,000, and operating expenses worth $3,000. Now, deducting operating expenses from the revenue, we get EBIT as $5,000 - $3,000 = $2,000. Thereafter, deducting the liabilities from total assets we reach to the capital employed as $10,000 - $2,000 = $8,000 at the begging of the period and $12,000 - $3,000 = $9,000 at the end of period. Then calculate average capital employed: ($8,000 + $9,000)/2 = $8,500. Finally, the return on average capital employed is obtained by dividing the EBIT by the average capital employed as $2,000 / $8,500 = 0.235, or 23.5%.
It is important for the investors to be cautious while using the ROACE as the capital assets, like refinery, can be depreciated over passing time. If an asset is generating the same amount of profit over every period, the depreciation of asset will lead to a higher ROACE which is less valuable. This reveals the company making good use of capital, although the company is actually not making any additional investments.