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Is Resonance Health Limited's (ASX:RHT) Capital Allocation Ability Worth Your Time?

Simply Wall St

Today we'll look at Resonance Health Limited (ASX:RHT) 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, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect its ROCE.

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

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. In brief, it is a useful tool, but it is not without drawbacks. 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 Resonance Health:

0.15 = AU$783k ÷ (AU$5.6m - AU$542k) (Based on the trailing twelve months to December 2018.)

So, Resonance Health has an ROCE of 15%.

View our latest analysis for Resonance Health

Does Resonance Health Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. It appears that Resonance Health's ROCE is fairly close to the Medical Equipment industry average of 15%. Separate from Resonance Health's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

Resonance Health reported an ROCE of 15% -- better than 3 years ago, when the company didn't make a profit. That implies the business has been improving. You can click on the image below to see (in greater detail) how Resonance Health's past growth compares to other companies.

ASX:RHT Past Revenue and Net Income, August 7th 2019

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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. How cyclical is Resonance Health? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

Do Resonance Health's Current Liabilities Skew 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Resonance Health has total liabilities of AU$542k and total assets of AU$5.6m. As a result, its current liabilities are equal to approximately 9.6% of its total assets. In addition to low current liabilities (making a negligible impact on ROCE), Resonance Health earns a sound return on capital employed.

What We Can Learn From Resonance Health's ROCE

If Resonance Health can continue reinvesting in its business, it could be an attractive prospect. Resonance Health 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.

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.