Today we'll look at Cadence Design Systems, Inc. (NASDAQ:CDNS) 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. 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 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. Overall, it is a valuable metric that has its flaws. 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 Cadence Design Systems:
0.25 = US$492m ÷ (US$2.6b - US$610m) (Based on the trailing twelve months to June 2019.)
Therefore, Cadence Design Systems has an ROCE of 25%.
Does Cadence Design Systems Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that Cadence Design Systems's ROCE is meaningfully better than the 9.9% average in the Software 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. Setting aside the comparison to its industry for a moment, Cadence Design Systems's ROCE in absolute terms currently looks quite high.
We can see that , Cadence Design Systems currently has an ROCE of 25% compared to its ROCE 3 years ago, which was 17%. This makes us think the business might be improving. You can see in the image below how Cadence Design Systems's ROCE compares to its industry. Click to see more on past growth.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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. Since the future is so important for investors, you should check out our free report on analyst forecasts for Cadence Design Systems.
What Are Current Liabilities, And How Do They Affect Cadence Design Systems'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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Cadence Design Systems has total assets of US$2.6b and current liabilities of US$610m. As a result, its current liabilities are equal to approximately 23% of its total assets. The fairly low level of current liabilities won't have much impact on the already great ROCE.
Our Take On Cadence Design Systems's ROCE
Low current liabilities and high ROCE is a good combination, making Cadence Design Systems look quite interesting. Cadence Design Systems 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.
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If you spot an error that warrants correction, please contact the editor at email@example.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.