Should You Worry About Slater and Gordon Limited’s (ASX:SGH) ROCE?

Today we’ll evaluate Slater and Gordon Limited (ASX:SGH) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First up, we’ll look at what ROCE is and how we calculate it. Second, we’ll look at its ROCE compared to similar companies. 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 metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. 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 Slater and Gordon:

0.046 = AU$12m ÷ (AU$339m – AU$81m) (Based on the trailing twelve months to June 2019.)

So, Slater and Gordon has an ROCE of 4.6%.

See our latest analysis for Slater and Gordon

Is Slater and Gordon’s ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. In this analysis, Slater and Gordon’s ROCE appears meaningfully below the 9.2% average reported by the Consumer Services 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, Slater and Gordon’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

Slater and Gordon has an ROCE of 4.6%, but it didn’t have an ROCE 3 years ago, since it was unprofitable. That suggests the business has returned to profitability. The image below shows how Slater and Gordon’s ROCE compares to its industry, and you can click it to see more detail on its past growth.

ASX:SGH Past Revenue and Net Income, January 31st 2020
ASX:SGH Past Revenue and Net Income, January 31st 2020

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. You can check if Slater and Gordon has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.

How Slater and Gordon’s Current Liabilities Impact Its ROCE

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that 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.

Slater and Gordon has current liabilities of AU$81m and total assets of AU$339m. Therefore its current liabilities are equivalent to approximately 24% of its total assets. It is good to see a restrained amount of current liabilities, as this limits the effect on ROCE.

Our Take On Slater and Gordon’s ROCE

That said, Slater and Gordon’s ROCE is mediocre, there may be more attractive investments around. You might be able to find a better investment than Slater and Gordon. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

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.

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. Thank you for reading.