Why Waterco Limited’s (ASX:WAT) Return On Capital Employed Looks Uninspiring

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Today we'll look at Waterco Limited (ASX:WAT) and reflect on its potential as an investment. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its 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.

What is Return On Capital Employed (ROCE)?

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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'.

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 Waterco:

0.06 = AU$5.7m ÷ (AU$124m - AU$31m) (Based on the trailing twelve months to December 2018.)

So, Waterco has an ROCE of 6.0%.

Check out our latest analysis for Waterco

Does Waterco Have A Good ROCE?

One way to assess ROCE is to compare similar companies. In this analysis, Waterco's ROCE appears meaningfully below the 13% average reported by the Leisure industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Setting aside the industry comparison for now, Waterco'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.

Waterco's current ROCE of 6.0% is lower than its ROCE in the past, which was 14%, 3 years ago. This makes us wonder if the business is facing new challenges.

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. You can check if Waterco has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.

Do Waterco's Current Liabilities Skew Its 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.

Waterco has total liabilities of AU$31m and total assets of AU$124m. As a result, its current liabilities are equal to approximately 25% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

What We Can Learn From Waterco's ROCE

If Waterco continues to earn an uninspiring ROCE, there may be better places to invest. You might be able to find a better investment than Waterco. 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).

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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.