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Are Southwest Airlines Co.’s (NYSE:LUV) High Returns Really That Great?

Simply Wall St

Today we'll evaluate Southwest Airlines Co. (NYSE:LUV) to determine whether it could have potential as an investment idea. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting 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. Generally speaking a higher ROCE is better. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'

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 Southwest Airlines:

0.17 = US$3.1b ÷ (US$26b - US$8.6b) (Based on the trailing twelve months to June 2019.)

Therefore, Southwest Airlines has an ROCE of 17%.

See our latest analysis for Southwest Airlines

Is Southwest Airlines's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that Southwest Airlines's ROCE is meaningfully better than the 12% average in the Airlines industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how Southwest Airlines compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

Southwest Airlines's current ROCE of 17% is lower than its ROCE in the past, which was 29%, 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 Southwest Airlines's past growth compares to other companies.

NYSE:LUV Past Revenue and Net Income, August 4th 2019

It is important to remember that ROCE shows past performance, and is 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Southwest Airlines's Current Liabilities And Their Impact On Its ROCE

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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.

Southwest Airlines has total assets of US$26b and current liabilities of US$8.6b. As a result, its current liabilities are equal to approximately 33% of its total assets. Southwest Airlines has a middling amount of current liabilities, increasing its ROCE somewhat.

What We Can Learn From Southwest Airlines's ROCE

With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. There might be better investments than Southwest Airlines 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.