Investors are always on the lookout for promising opportunities. They are not inclined to simply invest their hard-earned money in any random company. Rather, they want assurance that the company they are considering will use their investment effectively, thereby yielding favorable returns. There are numerous metrics and strategies to evaluate the financial performance of a potential investment target.
In this article, we will highlight a financial metric known as the return on average capital employed, often abbreviated as ROACE. Much like its counterparts, ROACE aims to depict the efficiency of a company, indicating how much profit the company can generate from each dollar of capital employed. Through this article, readers will gain insights into the ROACE metric, its calculation method, its potential limitations, how it stands in comparison to other financial metrics, and more.
What Is Return on Average Capital Employed (ROACE)?
ROACE is a financial metric used to assess a company's ability to generate profits relative to the capital that has been invested in it. A higher ROACE value typically signals better company performance. This ratio not only provides insights into a company's current performance but also allows for comparative evaluations.
For instance, by examining a company's ROACE over different time frames, one can discern whether the company is experiencing growth or if the company is on its way down in terms of its financial performance.
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An interesting point of distinction is that, while the return on capital employed (ROCE) metric is based solely on the closing capital value of a given period, ROACE, in contrast, takes into consideration the averages of both the opening and closing capital during that period. Such metrics are especially pertinent for industries that are capital-intensive by nature, examples of which include sectors like oil production, automobile manufacturing, telecommunications, and steel production.
To calculate ROACE you should use the following formula:
- EBIT stands for earnings before interest and taxes.
- ACE represents the average capital employed, which is determined by taking the average of the total assets and subtracting average current liabilities.
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It's important to note that, while some sources advocate the use of EBIAT (earnings before interest and after taxes) in the ROACE formula, the more widely accepted approach is the use of EBIT. The rationale behind adopting the average capital employed in this metric is to ensure that the valuation remains unaffected by such events as acquisitions, end-of-year fund raising, and other extraneous figures that could potentially distort the true financial picture.
For example, the value of an acquisition might present a skewed comparison between two companies when assessing through ROACE. This is because the acquisition would include profits from the newly acquired company post-acquisition but not prior. Yet, the entire assets of the acquired company would be reported at year's end. Such discrepancies can lead to an inaccurate decrease in the ROACE valuation. Also, if a company is raising funds in the year's last months, it employs this capital but most profits from it will appear only the next year. So it's better not to factor in this money.
Examples of ROACE
To better understand ROACE, let's consider a hypothetical scenario. Suppose there is an oil company named Ex Oil. At the start of 2022, this company has assets valued at $700,000 and liabilities amounting to $400,000. By year's end, the assets have increased to $900,000, with liabilities remaining consistent at $400,000. Over this year, Ex Oil reports earnings of $340,000, with operating expenses totaling $180,000.
Based on the above data, Ex Oil's EBIT (earnings before interest and taxes) would be $160,000 ($340,000 revenue minus $180,000 operating costs). Next, we compute the average capital employed for the year. The capital employed at the start of the year would be $300,000 ($700,000 assets minus $400,000 liabilities). By year's end, this figure rises to $500,000 ($900,000 assets minus $400,000 liabilities). Taking the average of these two values, we get an average capital employed of $400,000.
The final operation is counting ROACE. ROACE is $160,000 / $400,000 x 100% = 40%
Thus, for 2022, Ex Oil's ROACE stands at an impressive 40%.
Limitations of ROACE
Every financial metric has its limitations, and understanding these nuances is essential for effective utilization. ROACE is no exception. For instance, the depreciation of manufacturing equipment can erode a company's profits even if the same assets are used. Over time, the value of this machinery diminishes, yet ROACE doesn't accommodate for this depreciation.
Additionally, ROACE tends to overlook intangible assets such as brand value, copyrights, and patents. Even though these assets may significantly impact a company's financial health, they may not always be adequately represented on the balance sheet. Also, ROACE sidesteps variations in tax structures and rates, depending on the company's jurisdiction, since it doesn't factor in taxes. Considering ROACE doesn't take taxes into the formula, the metric doesn't factor differences in tax structures and rates depending on the region or the country of the company's jurisdiction.
It's worth noting that there's an ongoing debate among analysts regarding the use of EBIAT instead of EBIT in the ROACE formula. This discrepancy can be problematic because, when presented with a ROACE value, there's ambiguity over its tax considerations. Furthermore, like many ratios, ROACE can be artificially manipulated through strategic changes in accounts and capital structure representations.
ROACE vs Other Financial Metrics
Return on Capital Employed (ROCE): ROCE is perhaps the most comparable metric to ROACE. However, while ROACE evaluates the average capital employed over a given period (typically a year), ROCE focuses solely on the capital available at the period's end.
Return on Assets (ROA): ROA gauges a company's ability to generate profit from its total assets, including debt. ROACE, on the other hand, omits debt even though it can significantly influence a company's valuation. A substantially higher ROACE compared to ROA might suggest the company's heavy reliance on borrowed assets, signaling a riskier investment.
Return on Investment (ROI): ROI evaluates the profitability of specific assets or projects associated with a company, rather than the entire company's equity. For companies with diverse and intricate structures, ROACE might not be the best metric to measure returns on individual assets; ROI would be more apt in such cases.
ROACE stands out as a reliable metric to gauge a company's financial well-being. It often offers a more precise insight by excluding factors like end-of-year fund raises and acquisition values.
Although it bears certain limitations, ROACE is still highly regarded and offers certain advantages over its counterparts. Yet, for a holistic view, it's prudent to employ a combination of multiple metrics, bearing in mind the specific context. For example, within sectors like oil and gas or industries with massive capital turnovers, ROACE is particularly favored.
What is a good ROACE value?
A benchmark often cited is 35%, indicating robust financial performance. Generally, a value of around 20% is deemed satisfactory. However, what's considered "good" can fluctuate based on the industry. Often, the trend or dynamic is more vital for investors than the static value. A rising ROACE indicates positive growth, and if two competitors in the same sector have different ROACE values, the one with the higher value likely boasts better financial health.
How can a company enhance its ROACE rating?
Promptly settling liabilities and ramping up sales to amass more capital for additional assets acquisition are pivotal strategies to significantly uplift an ROACE rating.