Why American Software, Inc.’s (NASDAQ:AMSW.A) Return On Capital Employed Might Be A Concern

Today we'll look at American Software, Inc. (NASDAQ:AMSW.A) 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 'return' (pre-tax profit) a company generates from 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.'

How Do You Calculate Return On Capital Employed?

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 American Software:

0.076 = US$14m ÷ (US$157m - US$38m) (Based on the trailing twelve months to October 2018.)

Therefore, American Software has an ROCE of 7.6%.

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Does American Software Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, American Software's ROCE appears to be significantly below the 9.5% average in the Software industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how American Software stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.

As we can see, American Software currently has an ROCE of 7.6%, less than the 14% it reported 3 years ago. So investors might consider if it has had issues recently.

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. ROCE is, after all, simply a snap shot of a single year. Since the future is so important for investors, you should check out our freereport on analyst forecasts for American Software.

What Are Current Liabilities, And How Do They Affect American Software's ROCE?

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

American Software has total assets of US$157m and current liabilities of US$38m. As a result, its current liabilities are equal to approximately 25% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

The Bottom Line On American Software's ROCE

That said, American Software's ROCE is mediocre, there may be more attractive investments around. You might be able to find a better buy than American Software. If you want a selection of possible winners, check out this freelist of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

If you are like me, then you will not want to miss this freelist of growing companies that insiders are buying.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.