What Can We Make Of Seven Generations Energy Ltd.’s (TSE:VII) High Return On Capital?

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Today we’ll look at Seven Generations Energy Ltd. (TSE:VII) and reflect on its potential as an investment. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE to similar companies. Then we’ll determine how its current liabilities are affecting its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. 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 Seven Generations Energy:

0.11 = CA$820m ÷ (CA$8.2b – CA$518m) (Based on the trailing twelve months to March 2019.)

So, Seven Generations Energy has an ROCE of 11%.

Check out our latest analysis for Seven Generations Energy

Does Seven Generations Energy Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Seven Generations Energy’s ROCE is meaningfully higher than the 5.5% average in the Oil and Gas industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Independently of how Seven Generations Energy compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

Our data shows that Seven Generations Energy currently has an ROCE of 11%, compared to its ROCE of 7.1% 3 years ago. This makes us wonder if the company is improving.

TSX:VII Past Revenue and Net Income, June 19th 2019
TSX:VII Past Revenue and Net Income, June 19th 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 misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is, after all, simply a snap shot of a single year. Remember that most companies like Seven Generations Energy 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 Seven Generations Energy’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. 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.

Seven Generations Energy has total liabilities of CA$518m and total assets of CA$8.2b. Therefore its current liabilities are equivalent to approximately 6.3% of its total assets. In addition to low current liabilities (making a negligible impact on ROCE), Seven Generations Energy earns a sound return on capital employed.

The Bottom Line On Seven Generations Energy’s ROCE

If it is able to keep this up, Seven Generations Energy could be attractive. Seven Generations Energy shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.

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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.