Today we'll look at Frontline Ltd. (NYSE:FRO) 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.
Firstly, we'll go over how we 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.
Understanding 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. 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.'
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 Frontline:
0.046 = US$132m ÷ (US$3.1b - US$226m) (Based on the trailing twelve months to March 2019.)
So, Frontline has an ROCE of 4.6%.
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Is Frontline's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, Frontline's ROCE appears to be significantly below the 7.7% average in the Oil and Gas industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Regardless of how Frontline stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). There are potentially more appealing investments elsewhere.
Frontline's current ROCE of 4.6% is lower than 3 years ago, when the company reported a 8.6% ROCE. So investors might consider if it has had issues recently.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. We note Frontline could be considered a cyclical business. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
What Are Current Liabilities, And How Do They Affect Frontline'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 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.
Frontline has total assets of US$3.1b and current liabilities of US$226m. As a result, its current liabilities are equal to approximately 7.3% of its total assets. Frontline has very few current liabilities, which have a minimal effect on its already low ROCE.
What We Can Learn From Frontline's ROCE
Still, investors could probably find more attractive prospects with better performance out there. You might be able to find a better investment than Frontline. 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).
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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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.