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Here's What Altium Limited's (ASX:ALU) ROCE Can Tell Us

Simply Wall St

Today we'll look at Altium Limited (ASX:ALU) and reflect on its potential as an investment. 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 of all, we'll work out how to calculate ROCE. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that 'one dollar invested in the company generates value of more than one dollar'.

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 Altium:

0.31 = US$56m ÷ (US$237m - US$54m) (Based on the trailing twelve months to December 2018.)

Therefore, Altium has an ROCE of 31%.

Check out our latest analysis for Altium

Is Altium's ROCE Good?

One way to assess ROCE is to compare similar companies. Altium's ROCE appears to be substantially greater than the 19% average in the Software industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of the industry comparison, in absolute terms, Altium's ROCE currently appears to be excellent.

We can see that , Altium currently has an ROCE of 31% compared to its ROCE 3 years ago, which was 19%. This makes us think the business might be improving. The image below shows how Altium's ROCE compares to its industry, and you can click it to see more detail on its past growth.

ASX:ALU Past Revenue and Net Income, August 7th 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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Do Altium's Current Liabilities Skew Its ROCE?

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Altium has total assets of US$237m and current liabilities of US$54m. Therefore its current liabilities are equivalent to approximately 23% of its total assets. A minimal amount of current liabilities limits the impact on ROCE.

Our Take On Altium's ROCE

This is good to see, and with such a high ROCE, Altium may be worth a closer look. Altium 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.