U.S. markets open in 6 hours 52 minutes

Are The a2 Milk Company Limited’s (NZSE:ATM) High Returns Really That Great?

Simply Wall St

Today we'll look at The a2 Milk Company Limited (NZSE:ATM) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of 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. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. 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?

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 a2 Milk:

0.47 = NZ$459m ÷ (NZ$1.2b - NZ$209m) (Based on the trailing twelve months to December 2019.)

So, a2 Milk has an ROCE of 47%.

View our latest analysis for a2 Milk

Does a2 Milk Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that a2 Milk's ROCE is meaningfully better than the 8.2% average in the Food industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Setting aside the comparison to its industry for a moment, a2 Milk's ROCE in absolute terms currently looks quite high.

You can click on the image below to see (in greater detail) how a2 Milk's past growth compares to other companies.

NZSE:ATM Past Revenue and Net Income April 28th 2020

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for a2 Milk.

Do a2 Milk'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.

a2 Milk has current liabilities of NZ$209m and total assets of NZ$1.2b. As a result, its current liabilities are equal to approximately 18% of its total assets. The fairly low level of current liabilities won't have much impact on the already great ROCE.

Our Take On a2 Milk's ROCE

, a2 Milk 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.

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 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.

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. Thank you for reading.