U.S. Markets open in 6 hrs 23 mins

Are Allied Farmers Limited’s (NZSE:ALF) High Returns Really That Great?

Simply Wall St

Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!

Today we'll look at Allied Farmers Limited (NZSE:ALF) and reflect on its potential as an investment. 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 of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

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

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that 'one dollar invested in the company generates value of more than one dollar'.

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 Allied Farmers:

0.48 = NZ$3.7m ÷ (NZ$23m - NZ$16m) (Based on the trailing twelve months to December 2018.)

Therefore, Allied Farmers has an ROCE of 48%.

Check out our latest analysis for Allied Farmers

Does Allied Farmers Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Allied Farmers's ROCE is meaningfully higher than the 8.4% average in the Food industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Putting aside its position relative to its industry for now, in absolute terms, Allied Farmers's ROCE is currently very good.

NZSE:ALF Past Revenue and Net Income, June 17th 2019

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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. If Allied Farmers is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect Allied Farmers's 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.

Allied Farmers has total liabilities of NZ$16m and total assets of NZ$23m. As a result, its current liabilities are equal to approximately 67% of its total assets. While a high level of current liabilities boosts its ROCE, Allied Farmers's returns are still very good.

The Bottom Line On Allied Farmers's ROCE

So we would be interested in doing more research here -- there may be an opportunity! Allied Farmers looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

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.