Return on Average Capital Employed (RoACE) in Financial Analysis
While the return on capital employed is the most comprehensive indicator of the operating performance of a company, it is not the best indicator of the return earned by the investors of capital.
This is because RoCE is based on the operating profit of a company. The operating profit is not directly distributed to the fundholders of a company; hence, the return on capital employed calculations must be modified to calculate the return on average capital employed.
In the upcoming video, our faculty Marie-lys will explain the return on average capital employed (RoACE).
Some of the important points from the video above can be summarised as follows:
Net operating income indicates the operating income after paying taxes.
Adjusted net operating income indicates the operating income after paying taxes and excluding non-recurring items.
Average capital employed =
The drivers of return on average capital employed are the operating margin and capital employed turnover ratio.
With the help of the example of the TOTAL group, you learnt that analysing the RoACE of a company reveals the actual operating performance of the company.
In the next video, you will learn about the drivers of RoCE for the different business units of the TOTAL group of companies.
As you learnt in this video, a company aims to maximise both its efficiency and its margin in order to maximise its RoACE.
As you saw in the video, analysing the drivers of RoACE for the different business units revealed the area of low performance in that unit. Some units were high on margin but low on efficiency, and some were low on margin but high on efficiency.
Such an analysis helps the management to take the necessary actions to improve the low-performing driver for a unit, with the aim to increase the overall RoACE for the company.
In the next segment, you will learn about value creation.
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Transcript of the Video:
Let's open together the Total Financial Communication, this famous worldwide operating oil and
gas company.
They make public a very interesting measure, which is the RoACE. I know some of you may feel
like, oh, come on, we just introduced the RoCE and now we have to move on to the RoACE.
And I know it is a bit frustrating in finance. There are so many metrics. There are probably as
many metrics as companies.
But let's not panic. What we've learned will be helpful. Let's see how different Total RoACE is as
compared to our own return on capital employed.
So, look, that's the definition we decided upon for the RoCE. Operating income divided by capital
employed.
How does Total adapt this formula? Well at the numerator, the first thing they do is they take the
net operating income.
What does net mean? Net means after tax. Assume, for example, the tax rate is one-third. So,
they are saying, look, we've generated a certain amount of operating income.
We're not going to keep for the communication, this full operating income, we will consider that
one-third should go to the government through taxes.
And only two-third would be kept to reward our fund holders. It makes a lot of sense to
communicate in that way, because the numbers they make public are intended to shareholders
and shareholders are rewarded after taxes.
So, that's the first adaptation they do. The second adaptation they do at the numerator is they take
an adjusted net operating income.
Adjusted means excluding the non-recurring items, excluding the exceptional gains and the
exceptional losses.
So basically, they show a performance that we can judge to be sustainable over the long run.
And at the denominator, what do they do? They don't take the capital employed at the end of the
year, but they take an average capital employed.
They do an average between the numbers at the beginning and at the end of the year. Again, so
as to get rid of any exceptional fluctuation.
Many companies do that, it makes a lot of sense. And at the end of the day, RoACE stands for
return on average capital employed.
So, the formula is different. The numbers will be different in the end, but it's not a big deal. Let's
not panic.
Actually the underlying concept is exactly the same. It still highlights the overall performance of the
operations and the drivers of that performance will still be margin and efficiency.
Let's look at the numbers now. So, the RoACE of the entire company, it was 9.8% in 2019. It would
be more interesting and more fun to look at the numbers at business unit level.
So, actually Total carries four business units. Oil Exploration and Production is the first one and
the biggest one.
Integrated Gas Renewables and Power is the second one. Refining and Chemicals is the third
one. And marketing and services is the fourth one.
What do they have under marketing and services, essentially the petrol stations that you can find
downtown.
So, these are their four business units. Can you guess which one had the highest return on capital
employed last year? And that's been the case for the past years actually.
Let's look at the numbers together. That's the situation. And I bet some of you are pretty much
surprised by the results.
The business unit that carried the highest RoACE last year was Refining and Chemicals, closely
followed by Marketing and Services.
Exploration and Production had an RoACE that was below the group average. So, did Integrated
Gas Renewables and Power.
That's a bit counterintuitive because I think most of us were biased by the margin dimension. And
we feel like intuitively, you know, marketing and services, refining and chemicals are not business
units where total adds a lot of value to the products.
So, they shouldn't carry too high a margin. And that's why we jumped to conclusions and felt like
they wouldn't have a good RoACE either.
But that was forgetting about the efficiency dimension. And yes, refining and chemicals, marketing
and services carry low margin levels. But they are very, very efficient business units.
I could find some more information for you, and I managed to build this graph. Let's look at this
graph together.
On the X axis, you can see the adjusted net operating income as a percentage of sales. So, that's
the margin dimension of the return on average capital employed.
And what is the Y axis? The Y axis is sales divided by capital employed. That is, the capital
employed turnover. That's the efficiency dimension of the return on capital employed.
Where is the sweet spot? Well, the sweet spot is the north east corner. This is where all of us
would like to be with sky high margin and top-notch efficiency at the same time.
That's not always possible. Total has no business unit here, but it's interesting and fun to see that
they have business units that behave very differently.
For example, we were right to assume that Exploration and Production had the highest margin in
the group. That's true, close to 20%.
Would we be able to look at all their numbers, we could find even better margin levels in
Exploration and Production.
However, Exploration and Production carry a very low efficiency. Why is that? It's not that Total
doesn't perform okay. It's linked to the nature of this business.
It requires investment in very sophisticated pieces of equipment. Also, Total has to purchase all
fields all around the world to secure the supply of oil and gas in the upcoming decades.
So, they probably carry too much property, you know, because these are own fields that they don't
need for today business. They don't even use for today business.
But they must secure them now, otherwise it will be too late in 5, 10 or 20 years. So, by nature,
this is a business with a low efficiency level.
At the opposite, you can see Refining and Chemicals, Marketing and Services. As expected, they
have very low margin levels.
When we say low, it's really low. It's between 2 and 3%, that's not much, it must be managed very
carefully if you don't want to end up being at a loss.
However, these are highly attractive business units because they are very, very efficient.
In Refining and Chemicals, if you grant me $1 of capital employed, I can generate $10 of sales
revenue. That's very efficient and it more than compensates for the low level of margin.
So, it's interesting to see that Total has kept in its portfolio four different business units that
diversify their economic risks because they are not exposed to oil and gas price fluctuations the
same way.
But also they behave differently from an operating perspective point of view.
And at the end of the day, the group had an RoACE close to 10%, very much driven by the
performance of exploration and production still because this is the biggest business units in the
group.