What it means
Capital employed is the total money the business uses to operate. It is commonly calculated as total assets minus current liabilities, which is equal to equity plus long-term debt.
Looking at both shareholders' funds and lenders' funds shows how well all the capital is being used, not only the owners' share. ROACE refines the more common ROCE (return on capital employed) by using the average of the opening and closing capital employed.
This matters when a company has grown quickly, bought a business or repaid a large loan. Using only the closing figure would flatter a company that raised funds late in the year.
The numerator is earnings before interest and tax (EBIT), because the ratio measures operating performance before the way the business is financed. A result of 12% means that each dollar of capital employed generated 12 cents of operating profit.
Investors compare this with the company's cost of capital to see whether it is creating value. The ratio is especially popular in capital-intensive industries such as energy, utilities, mining and manufacturing, where large investments in plant and equipment are needed.
Comparing ROACE across companies in the same industry is more reliable than comparing across industries, since each has different normal levels. A trend over several years often reveals more than a single year.
Limitations include differences in accounting policies, asset valuations and the treatment of leases. A company with old, heavily depreciated assets may show a high ROACE simply because its book value is low.
Analysts should read it together with other measures such as margins and cash flow. Managers use the ratio internally as well.
Comparing ROACE by division shows which parts of the group earn the best return on the capital they use, and that can guide decisions about where to invest next and which operations to sell or fix.
In practice
Real-world examples.
Example
A mining company reports EBIT of $240,000,000 and average capital employed of $1,600,000,000. Its ROACE is 15%, which the board compares with its 9% cost of capital to confirm it is earning more than the capital costs. The directors take comfort from the 6-point gap but still ask for a breakdown by mine, since a strong average can hide a weak site.
Example
A retail chain opens many new stores late in the year, which pushes up closing capital employed. The finance team uses ROACE rather than closing-based ROCE, so that the new capital is weighted fairly when judging returns.
Example
An investor compares two utilities. One has ROACE of 6% and the other 10%, so she examines why the first earns less and finds that it has recently invested heavily in projects that have not yet started producing.
Formula
Calculation
ROACE = EBIT / Average capital employed
Average capital employed = (Opening capital employed + Closing capital employed) / 2
Suppose a company has EBIT of $12,000,000. Capital employed was $90,000,000 at the start of the year and $110,000,000 at the end. The average is ($90,000,000 + $110,000,000) / 2 = $100,000,000, so ROACE is $12,000,000 / $100,000,000 = 0.12, or 12%.Case study
Seen in the real world.
Redstone Engineering is an illustrative, fictional manufacturer that spent a large sum on a new factory in the final quarter of the year. Its closing capital employed jumped by $30,000,000, but the factory produced very little profit before the year end.
Using closing capital, the ratio looked poor. Using the average, as the finance director preferred, the drop was smaller and gave a fairer picture of the year as a whole. She also showed the board a pro forma figure, which adds a full year of the factory's expected profit and capital, so directors could see what the ratio might look like once the plant was running.
In this fictional case the following year's ROACE rose as the factory ramped up and began to deliver the profit the investment was meant to produce. The illustrative lesson is that an average smooths timing distortions, but a good analyst still looks at the trend over several years to see whether new investments pay off.
Watch out
Common mistakes.
- Using closing capital employed instead of the average when the capital base changed significantly during the year.
- Using net profit rather than EBIT in the numerator, which mixes financing costs into an operating measure.
- Comparing ROACE across industries with very different capital needs.
Questions
People also ask.
What is capital employed?
It is usually total assets minus current liabilities, which equals shareholders' equity plus long-term debt.
What is a good ROACE?
It depends on the industry, but a ratio above the company's cost of capital is generally a sign that it is creating value for investors.
How does ROACE differ from ROCE?
The only difference is the denominator, because ROACE uses the average of opening and closing capital employed while ROCE often uses the closing figure.
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