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Here's What Caterpillar Inc.'s (NYSE:CAT) ROCE Can Tell Us

Simply Wall St

Today we'll look at Caterpillar Inc. (NYSE:CAT) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

First, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. And finally, we'll look at how its current liabilities are impacting its ROCE.

Return On Capital Employed (ROCE): What is it?

ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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'.

How Do You Calculate Return On Capital Employed?

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 Caterpillar:

0.17 = US$8.5b ÷ (US$79b - US$28b) (Based on the trailing twelve months to June 2019.)

So, Caterpillar has an ROCE of 17%.

See our latest analysis for Caterpillar

Is Caterpillar's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that Caterpillar's ROCE is meaningfully better than the 11% average in the Machinery industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Independently of how Caterpillar compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

Our data shows that Caterpillar currently has an ROCE of 17%, compared to its ROCE of 6.0% 3 years ago. This makes us think the business might be improving. You can see in the image below how Caterpillar's ROCE compares to its industry. Click to see more on past growth.

NYSE:CAT Past Revenue and Net Income, July 30th 2019

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. ROCE is, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

How Caterpillar's Current Liabilities Impact Its ROCE

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Caterpillar has total liabilities of US$28b and total assets of US$79b. Therefore its current liabilities are equivalent to approximately 35% of its total assets. With this level of current liabilities, Caterpillar's ROCE is boosted somewhat.

What We Can Learn From Caterpillar's ROCE

Caterpillar's ROCE does look good, but the level of current liabilities also contribute to that. Caterpillar shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.

If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

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.