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Today we are going to look at ARC Resources Ltd. (TSE:ARX) to see whether it might be an attractive investment prospect. 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, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. And finally, we'll look at how its current liabilities are impacting its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested 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.'
So, How Do We Calculate ROCE?
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 ARC Resources:
0.056 = CA$323m ÷ (CA$6.0b - CA$285m) (Based on the trailing twelve months to December 2018.)
So, ARC Resources has an ROCE of 5.6%.
Is ARC Resources's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. We can see ARC Resources's ROCE is around the 6.4% average reported by the Oil and Gas industry. Aside from the industry comparison, ARC Resources's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.
ARC Resources reported an ROCE of 5.6% -- better than 3 years ago, when the company didn't make a profit. That implies the business has been improving.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. Given the industry it operates in, ARC Resources could be considered cyclical. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do ARC Resources's Current Liabilities Skew Its 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 counter this, investors can check if a company has high current liabilities relative to total assets.
ARC Resources has total liabilities of CA$285m and total assets of CA$6.0b. As a result, its current liabilities are equal to approximately 4.7% of its total assets. With low levels of current liabilities, at least ARC Resources's mediocre ROCE is not unduly boosted.
The Bottom Line On ARC Resources's ROCE
ARC Resources looks like an ok business, but on this analysis it is not at the top of our buy list. You might be able to find a better investment than ARC Resources. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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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 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.