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What Can We Make Of Lithia Motors, Inc.’s (NYSE:LAD) High Return On Capital?

Simply Wall St

Today we'll evaluate Lithia Motors, Inc. (NYSE:LAD) to determine whether it could have potential as an investment idea. 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 up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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 Lithia Motors:

0.15 = US$483m ÷ (US$5.7b - US$2.5b) (Based on the trailing twelve months to September 2019.)

Therefore, Lithia Motors has an ROCE of 15%.

See our latest analysis for Lithia Motors

Does Lithia Motors Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Lithia Motors's ROCE is meaningfully higher than the 11% average in the Specialty Retail 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. Separate from Lithia Motors's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

Lithia Motors's current ROCE of 15% is lower than 3 years ago, when the company reported a 20% ROCE. This makes us wonder if the business is facing new challenges. You can see in the image below how Lithia Motors's ROCE compares to its industry. Click to see more on past growth.

NYSE:LAD Past Revenue and Net Income, November 19th 2019

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. Since the future is so important for investors, you should check out our free report on analyst forecasts for Lithia Motors.

Lithia Motors's Current Liabilities And Their Impact On 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Lithia Motors has total assets of US$5.7b and current liabilities of US$2.5b. Therefore its current liabilities are equivalent to approximately 43% of its total assets. Lithia Motors has a medium level of current liabilities, which would boost the ROCE.

Our Take On Lithia Motors's ROCE

While its ROCE looks good, it's worth remembering that the current liabilities are making the business look better. There might be better investments than Lithia Motors out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.