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Today we’ll evaluate Sonic Healthcare Limited (ASX:SHL) to determine whether it could have potential as an investment idea. 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. Second, we’ll look at its ROCE compared to similar companies. Finally, we’ll look at how its current liabilities affect its ROCE.

Return On Capital Employed (ROCE): What is it?

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. 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?

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 Sonic Healthcare:

0.093 = AU$758m ÷ (AU$10.0b – AU$1.8b) (Based on the trailing twelve months to June 2019.)

Therefore, Sonic Healthcare has an ROCE of 9.3%.

View our latest analysis for Sonic Healthcare

Does Sonic Healthcare Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. We can see Sonic Healthcare’s ROCE is around the 9.4% average reported by the Healthcare industry. Separate from how Sonic Healthcare stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Readers may find more attractive investment prospects elsewhere.

You can see in the image below how Sonic Healthcare’s ROCE compares to its industry.

ASX:SHL Past Revenue and Net Income, September 21st 2019
ASX:SHL Past Revenue and Net Income, September 21st 2019

When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Since the future is so important for investors, you should check out our free report on analyst forecasts for Sonic Healthcare.

How Sonic Healthcare’s Current Liabilities Impact Its ROCE

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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.

Sonic Healthcare has total assets of AU$10.0b and current liabilities of AU$1.8b. As a result, its current liabilities are equal to approximately 19% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

What We Can Learn From Sonic Healthcare’s ROCE

With that in mind, we’re not overly impressed with Sonic Healthcare’s ROCE, so it may not be the most appealing prospect. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

I will like Sonic Healthcare better if I see some big insider buys. While we wait, check out this free list 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.