Today we'll look at Iluka Resources Limited (ASX:ILU) 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 of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
Return On Capital Employed (ROCE): What is it?
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 Iluka Resources:
0.27 = AU$492m ÷ (AU$2.2b - AU$407m) (Based on the trailing twelve months to December 2018.)
Therefore, Iluka Resources has an ROCE of 27%.
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Does Iluka Resources Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Iluka Resources's ROCE is meaningfully higher than the 9.5% average in the Metals and Mining industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Putting aside its position relative to its industry for now, in absolute terms, Iluka Resources's ROCE is currently very good.
As we can see, Iluka Resources currently has an ROCE of 27% compared to its ROCE 3 years ago, which was 7.5%. This makes us wonder if the company is improving.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is, after all, simply a snap shot of a single year. We note Iluka Resources could be considered a cyclical business. Since the future is so important for investors, you should check out our free report on analyst forecasts for Iluka Resources.
How Iluka Resources's Current Liabilities Impact Its ROCE
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Iluka Resources has total assets of AU$2.2b and current liabilities of AU$407m. Therefore its current liabilities are equivalent to approximately 18% of its total assets. The fairly low level of current liabilities won't have much impact on the already great ROCE.
Our Take On Iluka Resources's ROCE
This is good to see, and with such a high ROCE, Iluka Resources may be worth a closer look. Iluka Resources 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 firstname.lastname@example.org. 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.