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Today we’ll evaluate Western Areas Limited (ASX:WSA) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First up, we’ll look at what ROCE is and how we calculate it. Then we’ll compare its ROCE to similar companies. Finally, we’ll look at how its current liabilities affect its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. Generally speaking a higher ROCE is better. 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?
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 Western Areas:
0.028 = AU$15m ÷ (AU$572m – AU$48m) (Based on the trailing twelve months to June 2018.)
So, Western Areas has an ROCE of 2.8%.
Does Western Areas Have A Good ROCE?
One way to assess ROCE is to compare similar companies. In this analysis, Western Areas’s ROCE appears meaningfully below the 12% average reported by the Metals and Mining industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Regardless of how Western Areas stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). It is likely that there are more attractive prospects out there.
Western Areas’s current ROCE of 2.8% is lower than its ROCE in the past, which was 13%, 3 years ago. So investors might consider if it has had issues recently.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is only a point-in-time measure. Remember that most companies like Western Areas are cyclical businesses. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Western Areas.
Western Areas’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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Western Areas has total assets of AU$572m and current liabilities of AU$48m. Therefore its current liabilities are equivalent to approximately 8.4% of its total assets. Western Areas has very few current liabilities, which have a minimal effect on its already low ROCE.
Our Take On Western Areas’s ROCE
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To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.