Definition
Return on Average Capital Employed (ROACE) formula is a profitability ratio that measures a company’s profitability and the efficiency with which its capital is employed. It is calculated by dividing Net Operating Profit after Taxes (NOPAT) by the average capital employed during a particular time period. The result is often expressed as a percentage, showing the percentage of returns earned on the capital employed.
Key Takeaways
- The Return on Average Capital Employed (ROACE) formula is a financial ratio that measures a company’s profitability and the efficiency with which its capital is employed. It is calculated as Earnings Before Interest and Tax (EBIT) divided by the average total assets minus current liabilities.
- ROACE is used by investors, analysts and business managers to determine how a company is generating profits from its capital employed. A higher ROACE indicates a more efficient use of capital, and thus a more financially sound and successful company.
- The advantage of using ‘average’ capital employed in the formula is that it avoids distortions that can occur when there are significant changes in a company’s assets and liabilities. This helps to present a more accurate and reliable measure of a company’s profitability over time.
Importance
The Return on Average Capital Employed (ROACE) formula is a key financial metric used by businesses to evaluate their profitability and efficiency, which is important in guiding investment decisions.
This formula calculates the ratio of after-tax operating income to the average total capital invested in the business, providing insight into how well a company is generating profit from its capital.
A high ROACE indicates efficient use of capital, which can appeal to investors as it suggests that the company is likely to generate a higher return on their invested capital.
On the other hand, a lower ROACE could signal poor capital management or potentially risky investments.
Therefore, understanding and applying the ROACE formula can provide valuable insights about a company’s financial health and its potential future performance.
Explanation
The Return on Average Capital Employed (ROACE) Formula is an important financial metric that is used by companies, investors, and financial analysts to gauge the efficiency with which a company is able to generate profits from its capital employed. It is a measure of a firm’s profitability and the efficiency with which its capital is used.
By comparing the net earnings of a business entity to its employed capital, the formula provides a snapshot of how profitably a company is utilizing its available resources. The primary purpose of the ROACE formula is to provide insights into the overall financial health and operating efficiency of the company.
It assists in determining the company’s ability to increase shareholder value and in signaling how effectively management is utilizing the company’s capital. It is also used by investors and shareholders to compare the performance of different companies in the same industry, effectively serving as a barometer for investment decisions.
Thus, a high ROACE can often be an indication of strong financial performance.
Examples of Return on Average Capital Employed Formula
Manufacturing Industry: A factory manufacturing toys consistently generates a net profit of $500,000 per year. The average total assets employed in the manufacturing operations over the year amount to $2,000,
Using the Return on Average Capital Employed (ROACE) formula, the ROACE would be $500,000/$2,000,000, or 25%. This indicates that for every dollar invested in the business, the company generates 25 cents of profit.
Retail Industry: Consider a retailer that has an average total capital employed of $10 million and earns an EBIT (Earnings Before Interest and Taxes) of $1 million in a fiscal year. The ROACE would be calculated as $1,000,000/$10,000,000, or 10%. This means that the company made a return of 10% on the capital it used during the year.
Tech Industry: An internet service provider has an average total capital employed of $30 million for a financial year and their operating profit (after taxes) for that year is $6 million. So, the Return on Average Capital Employed would be calculated as ($6 million/$30 million) * 100, resulting in a 20% return. This shows that the company is efficiently using its capital to generate profits.
FAQ for Return on Average Capital Employed Formula
What is Return on Average Capital Employed (ROACE)?
Return on Average Capital Employed (ROACE) is a profitability ratio that measures how effectively a company is using its capital to generate profits. It is usually expressed as a percentage, and a higher percentage means that the company is more efficient at generating profits from its capital.
How is ROACE calculated?
ROACE is calculated by dividing the net operating profit (or EBIT) by the average total assets minus current liabilities. The formula is: ROACE = Net Operating Profit / (Total Assets – Current Liabilities).
What does a high ROACE indicate?
A high ROACE indicates that the company is efficient at using its capital to generate profits. It’s a good sign that the company’s management is using the capital wisely and that the company is likely to be profitable in the future.
What does a low ROACE indicate?
A low ROACE indicates that the company is not very efficient at using its capital to generate profits. This could be a sign of poor management or a sign that the company is in a difficult industry where it’s hard to make a profit.
How to use ROACE in investment decisions?
Investors should look at a company’s ROACE in comparison to its competitors and the industry average. A company with a higher ROACE is likely to be a better investment than a company with a lower ROACE, all other things being equal.
Related Entrepreneurship Terms
- Average Capital Employed
- Operating Profit
- Cash Flow Statement
- Financial Analysis
- Profit Margin
Sources for More Information
- Investopedia: A comprehensive resource for investing and finance education. It offers a variety of information including articles, tutorials, and dictionaries.
- AccountingCoach: Offers accounting lessons for free, it’s a great resource for anyone wanting to better understand finance and accounting principles.
- Corporate Finance Institute (CFI): A leading provider of online financial analyst certification and training programs and resources. It offers various guides, templates, articles, and resources for finance studies.
- WallStreetMojo: A resource for financial education geared towards investment banking, private equity, and commercial banking careers. It provides articles, guides, and courses related to finance and investments.
