Should Northgate plc’s (LON:NTG) Weak Investment Returns Worry You?

Today we are going to look at Northgate plc (LON:NTG) to see whether it might be an attractive investment prospect. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'

How Do You Calculate Return On Capital Employed?

The formula for calculating the return on capital employed is:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

Or for Northgate:

0.076 = UK£75m ÷ (UK£1.1b - UK£130m) (Based on the trailing twelve months to April 2019.)

So, Northgate has an ROCE of 7.6%.

View our latest analysis for Northgate

Is Northgate's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, Northgate's ROCE appears to be significantly below the 13% average in the Transportation industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Aside from the industry comparison, Northgate's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.

Northgate's current ROCE of 7.6% is lower than 3 years ago, when the company reported a 12% ROCE. Therefore we wonder if the company is facing new headwinds.

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

What Are Current Liabilities, And How Do They Affect Northgate's ROCE?

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Northgate has total assets of UK£1.1b and current liabilities of UK£130m. As a result, its current liabilities are equal to approximately 12% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

Our Take On Northgate's ROCE

With that in mind, we're not overly impressed with Northgate's ROCE, so it may not be the most appealing prospect. Of course, you might also be able to find a better stock than Northgate. So you may wish to see this free collection of other companies that have grown earnings strongly.

I will like Northgate better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.