Today we are going to look at Western Areas Limited (ASX:WSA) to see whether it might be an attractive investment prospect. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
Firstly, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. And finally, we’ll look at how its current liabilities are impacting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. All else being equal, a better business will have a higher ROCE. In brief, it is a useful tool, but it is not without drawbacks. 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 Western Areas:
0.018 = AU$10m ÷ (AU$597m – AU$53m) (Based on the trailing twelve months to June 2019.)
Therefore, Western Areas has an ROCE of 1.8%.
Is Western Areas’s ROCE Good?
One way to assess ROCE is to compare similar companies. We can see Western Areas’s ROCE is meaningfully below the Metals and Mining industry average of 8.0%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Independently of how Western Areas compares to its industry, its ROCE in absolute terms is low; especially compared to the ~1.1% available in government bonds. Readers may wish to look for more rewarding investments.
Western Areas reported an ROCE of 1.8% — better than 3 years ago, when the company didn’t make a profit. That suggests the business has returned to profitability. You can click on the image below to see (in greater detail) how Western Areas’s past growth compares to other companies.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. Given the industry it operates in, Western Areas could be considered cyclical. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Western Areas.
Do Western Areas’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. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.
Western Areas has total assets of AU$597m and current liabilities of AU$53m. As a result, its current liabilities are equal to approximately 9.0% of its total assets. With barely any current liabilities, there is minimal impact on Western Areas’s admittedly low ROCE.
What We Can Learn From Western Areas’s ROCE
Nonetheless, there may be better places to invest your capital. You might be able to find a better investment than Western Areas. 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).
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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