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What Can We Make Of Frontier Developments plc’s (LON:FDEV) High Return On Capital?

Simply Wall St

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Today we'll look at Frontier Developments plc (LON:FDEV) 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 up, we'll look at what ROCE is and how we calculate it. Next, we'll compare it to others in its industry. 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 is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. 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?

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 Frontier Developments:

0.25 = UK£17m ÷ (UK£84m - UK£15m) (Based on the trailing twelve months to November 2018.)

Therefore, Frontier Developments has an ROCE of 25%.

Check out our latest analysis for Frontier Developments

Is Frontier Developments's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Frontier Developments's ROCE is meaningfully higher than the 5.7% average in the Entertainment industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Regardless of the industry comparison, in absolute terms, Frontier Developments's ROCE currently appears to be excellent.

Our data shows that Frontier Developments currently has an ROCE of 25%, compared to its ROCE of 17% 3 years ago. This makes us wonder if the company is improving.

AIM:FDEV Past Revenue and Net Income, May 2nd 2019

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. 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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Frontier Developments.

Frontier Developments's Current Liabilities And Their Impact On Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Frontier Developments has total liabilities of UK£15m and total assets of UK£84m. As a result, its current liabilities are equal to approximately 17% of its total assets. A minimal amount of current liabilities limits the impact on ROCE.

What We Can Learn From Frontier Developments's ROCE

With low current liabilities and a high ROCE, Frontier Developments could be worthy of further investigation. Frontier Developments 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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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.