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Are Lucara Diamond Corp.’s (TSE:LUC) High Returns Really That Great?

Simply Wall St

Today we'll look at Lucara Diamond Corp. (TSE:LUC) 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 of all, we'll work out how to 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.

What is Return On Capital Employed (ROCE)?

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. 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?

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 Lucara Diamond:

0.068 = US$22m ÷ (US$346m - US$22m) (Based on the trailing twelve months to December 2019.)

So, Lucara Diamond has an ROCE of 6.8%.

View our latest analysis for Lucara Diamond

Is Lucara Diamond's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. Lucara Diamond's ROCE appears to be substantially greater than the 3.7% 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. Aside from the industry comparison, Lucara Diamond's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

We can see that, Lucara Diamond currently has an ROCE of 6.8%, less than the 64% it reported 3 years ago. Therefore we wonder if the company is facing new headwinds. You can click on the image below to see (in greater detail) how Lucara Diamond's past growth compares to other companies.

TSX:LUC Past Revenue and Net Income, February 26th 2020

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 only a point-in-time measure. We note Lucara Diamond 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 Lucara Diamond.

What Are Current Liabilities, And How Do They Affect Lucara Diamond's 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Lucara Diamond has current liabilities of US$22m and total assets of US$346m. Therefore its current liabilities are equivalent to approximately 6.2% of its total assets. With low levels of current liabilities, at least Lucara Diamond's mediocre ROCE is not unduly boosted.

Our Take On Lucara Diamond's ROCE

If performance improves, then Lucara Diamond may be an OK investment, especially at the right valuation. Of course, you might also be able to find a better stock than Lucara Diamond. So you may wish to see this free collection of other companies that have grown earnings strongly.

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

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.

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. Thank you for reading.