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Evaluating South32 Limited’s (ASX:S32) Investments In Its Business

Simply Wall St

Today we are going to look at South32 Limited (ASX:S32) to see whether it might be an attractive investment prospect. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First up, we'll look at what ROCE is and how we calculate it. 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.

What is Return On Capital Employed (ROCE)?

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. 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?

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 South32:

0.073 = US$946m ÷ (US$15b - US$1.7b) (Based on the trailing twelve months to June 2019.)

So, South32 has an ROCE of 7.3%.

Check out our latest analysis for South32

Is South32's ROCE Good?

One way to assess ROCE is to compare similar companies. It appears that South32's ROCE is fairly close to the Metals and Mining industry average of 8.0%. Aside from the industry comparison, South32's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.

We can see that, South32 currently has an ROCE of 7.3% compared to its ROCE 3 years ago, which was 1.7%. This makes us think the business might be improving. You can click on the image below to see (in greater detail) how South32's past growth compares to other companies.

ASX:S32 Past Revenue and Net Income, December 4th 2019

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. 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. Remember that most companies like South32 are cyclical businesses. Since the future is so important for investors, you should check out our free report on analyst forecasts for South32.

South32's Current Liabilities And Their Impact On Its 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 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.

South32 has total liabilities of US$1.7b and total assets of US$15b. As a result, its current liabilities are equal to approximately 11% of its total assets. It is good to see a restrained amount of current liabilities, as this limits the effect on ROCE.

Our Take On South32's ROCE

With that in mind, we're not overly impressed with South32's ROCE, so it may not be the most appealing prospect. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

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.