Why Washington H. Soul Pattinson and Company Limited’s (ASX:SOL) Return On Capital Employed Might Be A Concern

Today we'll look at Washington H. Soul Pattinson and Company Limited (ASX:SOL) 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. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the amount of pre-tax profits a company can generate from the 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'.

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 Washington H. Soul Pattinson:

0.066 = AU$366m ÷ (AU$5.9b - AU$305m) (Based on the trailing twelve months to July 2019.)

Therefore, Washington H. Soul Pattinson has an ROCE of 6.6%.

View our latest analysis for Washington H. Soul Pattinson

Does Washington H. Soul Pattinson Have A Good ROCE?

One way to assess ROCE is to compare similar companies. We can see Washington H. Soul Pattinson's ROCE is meaningfully below the Oil and Gas industry average of 11%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Setting aside the industry comparison for now, Washington H. Soul Pattinson'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.

In our analysis, Washington H. Soul Pattinson's ROCE appears to be 6.6%, compared to 3 years ago, when its ROCE was 2.4%. This makes us wonder if the company is improving. The image below shows how Washington H. Soul Pattinson's ROCE compares to its industry, and you can click it to see more detail on its past growth.

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is, after all, simply a snap shot of a single year. Given the industry it operates in, Washington H. Soul Pattinson could be considered cyclical. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Washington H. Soul Pattinson's Current Liabilities And Their Impact On 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Washington H. Soul Pattinson has total assets of AU$5.9b and current liabilities of AU$305m. As a result, its current liabilities are equal to approximately 5.2% of its total assets. Washington H. Soul Pattinson reports few current liabilities, which have a negligible impact on its unremarkable ROCE.

Our Take On Washington H. Soul Pattinson's ROCE

Washington H. Soul Pattinson looks like an ok business, but on this analysis it is not at the top of our buy list. You might be able to find a better investment than Washington H. Soul Pattinson. 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.