Why You Should Care About Kratos Defense & Security Solutions, Inc.’s (NASDAQ:KTOS) Low Return On Capital

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Today we’ll evaluate Kratos Defense & Security Solutions, Inc. (NASDAQ:KTOS) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

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 is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the 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?

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 Kratos Defense & Security Solutions:

0.041 = US$34m ÷ (US$1.0b – US$165m) (Based on the trailing twelve months to December 2018.)

So, Kratos Defense & Security Solutions has an ROCE of 4.1%.

View our latest analysis for Kratos Defense & Security Solutions

Is Kratos Defense & Security Solutions’s ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. We can see Kratos Defense & Security Solutions’s ROCE is meaningfully below the Aerospace & Defense industry average of 11%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Putting aside Kratos Defense & Security Solutions’s performance relative to its industry, its ROCE in absolute terms is poor – considering the risk of owning stocks compared to government bonds. There are potentially more appealing investments elsewhere.

Kratos Defense & Security Solutions reported an ROCE of 4.1% — better than 3 years ago, when the company didn’t make a profit. That suggests the business has returned to profitability.

NasdaqGS:KTOS Past Revenue and Net Income, May 1st 2019
NasdaqGS:KTOS Past Revenue and Net Income, May 1st 2019

It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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 Kratos Defense & Security Solutions.

Do Kratos Defense & Security Solutions’s Current Liabilities Skew Its ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Kratos Defense & Security Solutions has total assets of US$1.0b and current liabilities of US$165m. As a result, its current liabilities are equal to approximately 16% of its total assets. With a very reasonable level of current liabilities, so the impact on ROCE is fairly minimal.

What We Can Learn From Kratos Defense & Security Solutions’s ROCE

Kratos Defense & Security Solutions has a poor ROCE, and there may be better investment prospects out there. 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).

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.