Definition
Return on Average Capital Employed (ROACE) is a financial performance ratio that measures a company’s profitability and the efficiency with which its capital is being used. In specific, it evaluates how well a company can generate profits from its capital employed by comparing net operating profit to the average capital employed. A high ROACE value might indicate that the company is using its capital efficiently to generate profits.
Phonetic
The phonetics of the keyword: Return on Average Capital Employed (ROACE) would be: rɪˈtɜrn ɒn ˈævərɪʤ ˈkæpɪtəl ɪmˈplɔɪd (ɹoʊ-æ-si)
Key Takeaways
<ol><li>Assessment of Profitability: Return on Average Capital Employed (ROACE) is an essential financial ratio that indicates the profitability and efficiency of a company. It measures the company’s ability to generate earnings from its capital employed, essentially telling potential investors how well the firm is utilizing its resources to generate profits.</li><li>Performance Comparison: While raw profit values can be misleading, ROACE offers a basis for comparing the performance of companies across various industries and sizes. Businesses with a higher ROACE are generally considered better investments because they’re more likely to use their capital effectively.</li><li>Understanding Business Risks: Beyond profitability, ROACE can also give stakeholders an insight into the potential risks associated with the business. A consistently low or declining ROACE may indicate inefficient use of capital or an overly risky business model. It can be a signal for the management or investors to reconsider the company’s business strategies.</li></ol>
Importance
Return on Average Capital Employed (ROACE) is a critical metric in business finance as it measures a company’s profitability in relation to its overall available resources. Essentially, it helps determine how effectively a company is using its capital to generate profits. A higher ROACE indicates better use of capital, demonstrating efficient financial management and potentially more valuable investment opportunities. On the other hand, a low ROACE may indicate that a company is not generating a reasonable profit given the amount of capital it has at its disposal. This financial indicator can be used by investors, stakeholders, and company management to make informed decisions about business performance, capital allocation, and strategic planning.
Explanation
The purpose of the Return on Average Capital Employed (ROACE) in finance or business is to measure a company’s profitability and efficiency in using its capital. This term aids in determining how well a company generates profits from its capital directly involved in producing its revenues. By providing a snapshot of financial performance, ROACE is often utilized by investors, business owners, and financial analysts to compare profitability across businesses within the same industry, or to track a single company’s performance over time. ROACE is useful because it considers the average capital invested in a company over a specific period, thus offering a more accurate picture of performance, particularly in businesses where capital investment varies significantly within a year. Additionally, when used for assessments concerning potential investments, ROACE can help determine if firms are earning an acceptable rate of return on the capital employed in business operations. This information can help investors make more informed investment decisions.
Examples
1. Apple Inc.: As of 2020, Apple’s ROACE was calculated to be around 29.5%, indicating that the company generated approximately $0.30 of profit for every dollar invested in capital. This figure shows that Apple is efficient at using its capital to generate profits, making it appealing to investors.2. ExxonMobil: In 2019, the energy company ExxonMobil reported a ROACE of around 6.9%. It showed that, for every dollar of capital employed, ExxonMobil was able to produce nearly $0.07 in profit, a reasonable return in the energy sector considering the capital-intense nature of the industry.3. Jaguar Land Rover: The automobile company Jaguar Land Rover reported a ROACE of 7.5% in 2018. This indicates that, for each pound of capital employed, the company generated 7.5 pence in returns. Although it shows the company is generating returns on its capital employed, it’s comparatively lower than companies in other sectors, reflecting the high capital investment requirements and stiff competition in automobile sector.
Frequently Asked Questions(FAQ)
What is Return on Average Capital Employed (ROACE)?
Return on Average Capital Employed (ROACE) is a financial ratio that measures a company’s profitability and the efficiency with which its capital is employed. It is calculated by dividing a company’s operating income by its average capital employed.
How is ROACE calculated?
ROACE is calculated by dividing the company’s earnings before interest and tax (EBIT) by its average capital employed during a certain period. The formula is: ROACE = EBIT / Average Capital Employed.
Why is ROACE important?
ROACE is important because it allows investors and analysts to see how well a company is using its capital to generate profit. A higher ROACE indicates the company is employing its capital more efficiently.
How does ROACE differ from Return on Capital Employed (ROCE)?
While both ratios essentially measure the same thing – a company’s profitability relative to its capital – the difference lies in the denominator. ROCE uses the total capital employed at the end of a period, while ROACE averages the capital employed at the beginning and end of a period.
What is considered a good ROACE?
A good ROACE can vary between industries, but as a general rule, a ROACE that is higher than the cost of capital indicates a company is employing its capital effectively and generating value. It’s also good to compare a company’s ROACE with its competitors.
How can a company improve its ROACE?
A company can improve its ROACE by either increasing its earnings before interest and taxes (EBIT) or efficiently managing and reducing its average capital employed. This could mean streamlining operations to increase profits or disposing of unproductive assets to reduce capital employed.
Can I use ROACE to compare different companies?
Yes, ROACE can be used to compare the performance of different companies. However, it’s important to compare companies within the same industry because capital intensity can vary greatly between industries. The ROACE of a manufacturing company, for instance, should not be compared with that of a software company.
Related Finance Terms
- Capital Employed
- Net Operating Profit
- Investment Efficiency
- Financial Performance Indicator
- Asset Turnover Ratio
Sources for More Information
