Today we'll evaluate FutureFuel Corp. (NYSE:FF) to determine whether it could have potential as an investment idea. 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. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the 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.
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 FutureFuel:
0.042 = US$18m ÷ (US$484m - US$40m) (Based on the trailing twelve months to September 2019.)
So, FutureFuel has an ROCE of 4.2%.
Is FutureFuel's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. We can see FutureFuel's ROCE is meaningfully below the Chemicals industry average of 10%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Putting aside FutureFuel's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. It is likely that there are more attractive prospects out there.
We can see that, FutureFuel currently has an ROCE of 4.2%, less than the 10% it reported 3 years ago. Therefore we wonder if the company is facing new headwinds. The image below shows how FutureFuel's ROCE compares to its industry, and you can click it to see more detail on its 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is FutureFuel? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect FutureFuel's ROCE?
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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.
FutureFuel has total assets of US$484m and current liabilities of US$40m. Therefore its current liabilities are equivalent to approximately 8.2% of its total assets. FutureFuel has very few current liabilities, which have a minimal effect on its already low ROCE.
What We Can Learn From FutureFuel's ROCE
Still, investors could probably find more attractive prospects with better performance out there. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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.
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