Here’s why Ariadne Australia Limited’s (ASX:ARA) Returns On Capital Matters So Much

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Today we’ll look at Ariadne Australia Limited (ASX:ARA) 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.

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.

Understanding 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.’

So, How Do We Calculate ROCE?

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 Ariadne Australia:

0.11 = AU$18m ÷ (AU$172m – AU$7.7m) (Based on the trailing twelve months to December 2018.)

So, Ariadne Australia has an ROCE of 11%.

See our latest analysis for Ariadne Australia

Does Ariadne Australia Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. We can see Ariadne Australia’s ROCE is meaningfully below the Commercial Services industry average of 18%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Independently of how Ariadne Australia compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

Ariadne Australia reported an ROCE of 11% — better than 3 years ago, when the company didn’t make a profit. That implies the business has been improving.

ASX:ARA Past Revenue and Net Income, May 13th 2019
ASX:ARA Past Revenue and Net Income, May 13th 2019

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 only a point-in-time measure. You can check if Ariadne Australia has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect Ariadne Australia’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. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Ariadne Australia has total liabilities of AU$7.7m and total assets of AU$172m. Therefore its current liabilities are equivalent to approximately 4.5% of its total assets. With low current liabilities, Ariadne Australia’s decent ROCE looks that much more respectable.

Our Take On Ariadne Australia’s ROCE

This is good to see, and while better prospects may exist, Ariadne Australia seems worth researching further. Ariadne Australia shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.

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

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.