What Can We Make Of Fortuna Silver Mines Inc.’s (TSE:FVI) High Return On Capital?

Today we'll evaluate Fortuna Silver Mines Inc. (TSE:FVI) to determine whether it could have potential as an investment idea. Specifically, we'll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.

First of all, we'll work out how to calculate ROCE. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect 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. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that 'one dollar invested in the company generates value of more than one dollar'.

How Do You Calculate Return On Capital Employed?

Analysts use this formula to calculate return on capital employed:

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

Or for Fortuna Silver Mines:

0.061 = US$48m ÷ (US$871m - US$81m) (Based on the trailing twelve months to September 2019.)

So, Fortuna Silver Mines has an ROCE of 6.1%.

Check out our latest analysis for Fortuna Silver Mines

Is Fortuna Silver Mines's ROCE Good?

One way to assess ROCE is to compare similar companies. Using our data, we find that Fortuna Silver Mines's ROCE is meaningfully better than the 3.8% average in the Metals and Mining industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Separate from how Fortuna Silver Mines stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.

In our analysis, Fortuna Silver Mines's ROCE appears to be 6.1%, compared to 3 years ago, when its ROCE was 4.2%. This makes us think about whether the company has been reinvesting shrewdly. You can click on the image below to see (in greater detail) how Fortuna Silver Mines's past growth compares to other companies.

When considering this metric, keep in mind that it is backwards looking, and 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. ROCE is, after all, simply a snap shot of a single year. We note Fortuna Silver Mines could be considered a cyclical business. Since the future is so important for investors, you should check out our free report on analyst forecasts for Fortuna Silver Mines.

What Are Current Liabilities, And How Do They Affect Fortuna Silver Mines'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 counter this, investors can check if a company has high current liabilities relative to total assets.

Fortuna Silver Mines has current liabilities of US$81m and total assets of US$871m. As a result, its current liabilities are equal to approximately 9.2% of its total assets. Fortuna Silver Mines has a low level of current liabilities, which have a minimal impact on its uninspiring ROCE.

Our Take On Fortuna Silver Mines's ROCE

Fortuna Silver Mines looks like an ok business, but on this analysis it is not at the top of our buy list. Of course, you might also be able to find a better stock than Fortuna Silver Mines. So you may wish to see this free collection of other companies that have grown earnings strongly.

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.