Why Lynas Corporation Limited’s (ASX:LYC) Return On Capital Employed Might Be A Concern

Today we'll look at Lynas Corporation Limited (ASX:LYC) and reflect on its potential as an investment. 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. Then we'll determine how its current liabilities are affecting its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'

So, How Do We Calculate ROCE?

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 Lynas:

0.063 = AU$49m ÷ (AU$813m - AU$42m) (Based on the trailing twelve months to December 2018.)

Therefore, Lynas has an ROCE of 6.3%.

View our latest analysis for Lynas

Is Lynas's ROCE Good?

One way to assess ROCE is to compare similar companies. Using our data, Lynas's ROCE appears to be significantly below the 8.3% average in the Metals and Mining industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Aside from the industry comparison, Lynas's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.

Lynas delivered an ROCE of 6.3%, which is better than 3 years ago, as was making losses back then. That implies the business has been improving.

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. We note Lynas could be considered a cyclical business. Since the future is so important for investors, you should check out our freereport on analyst forecasts for Lynas.

Do Lynas's Current Liabilities Skew Its ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.

Lynas has total liabilities of AU$42m and total assets of AU$813m. Therefore its current liabilities are equivalent to approximately 5.2% of its total assets. Lynas reports few current liabilities, which have a negligible impact on its unremarkable ROCE.

Our Take On Lynas's ROCE

If performance improves, then Lynas may be an OK investment, especially at the right valuation. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this freelist of companies with modest (or no) debt, trading on a P/E below 20.

I will like Lynas better if I see some big insider buys. While we wait, check out this freelist 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.