Why We’re Not Keen On Granite Oil Corp.’s (TSE:GXO) 2.9% Return On Capital

Today we’ll evaluate Granite Oil Corp. (TSE:GXO) to determine whether it could have potential as an investment idea. Specifically, we’ll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.

First up, we’ll look at what ROCE is and how we calculate it. Then we’ll compare its ROCE to similar companies. Finally, we’ll look at how its current liabilities affect its ROCE.

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

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. 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 Granite Oil:

0.029 = CA$6.6m ÷ (CA$273m – CA$48m) (Based on the trailing twelve months to June 2019.)

Therefore, Granite Oil has an ROCE of 2.9%.

View our latest analysis for Granite Oil

Is Granite Oil’s ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Granite Oil’s ROCE appears meaningfully below the 5.7% average reported by the Oil and Gas industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Independently of how Granite Oil compares to its industry, its ROCE in absolute terms is low; especially compared to the ~1.9% available in government bonds. Readers may wish to look for more rewarding investments.

Our data shows that Granite Oil currently has an ROCE of 2.9%, compared to its ROCE of 0.6% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly.

TSX:GXO Past Revenue and Net Income, September 2nd 2019
TSX:GXO Past Revenue and Net Income, September 2nd 2019

Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. 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. Remember that most companies like Granite Oil are cyclical businesses. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

What Are Current Liabilities, And How Do They Affect Granite Oil’s 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 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Granite Oil has total assets of CA$273m and current liabilities of CA$48m. As a result, its current liabilities are equal to approximately 18% of its total assets. With a very reasonable level of current liabilities, so the impact on ROCE is fairly minimal.

Our Take On Granite Oil’s ROCE

While that is good to see, Granite Oil has a low ROCE and does not look attractive in this analysis. You might be able to find a better investment than Granite Oil. 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).

Granite Oil is not the only stock insiders are buying. So take a peek at this free list of growing companies with 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.