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Here’s why Algonquin Power & Utilities Corp.’s (TSE:AQN) Returns On Capital Matters So Much

Simply Wall St

Today we'll look at Algonquin Power & Utilities Corp. (TSE:AQN) 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. Then we'll determine how its current liabilities are affecting 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. 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?

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 Algonquin Power & Utilities:

0.037 = US$355m ÷ (US$10b - US$454m) (Based on the trailing twelve months to June 2019.)

So, Algonquin Power & Utilities has an ROCE of 3.7%.

View our latest analysis for Algonquin Power & Utilities

Does Algonquin Power & Utilities Have A Good ROCE?

One way to assess ROCE is to compare similar companies. Using our data, Algonquin Power & Utilities's ROCE appears to be significantly below the 5.0% average in the Integrated Utilities industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Putting aside Algonquin Power & Utilities's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. It is likely that there are more attractive prospects out there.

The image below shows how Algonquin Power & Utilities's ROCE compares to its industry, and you can click it to see more detail on its past growth.

TSX:AQN Past Revenue and Net Income, October 21st 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. 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.

What Are Current Liabilities, And How Do They Affect Algonquin Power & Utilities's ROCE?

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

Algonquin Power & Utilities has total assets of US$10b and current liabilities of US$454m. Therefore its current liabilities are equivalent to approximately 4.5% of its total assets. Algonquin Power & Utilities has very few current liabilities, which have a minimal effect on its already low ROCE.

What We Can Learn From Algonquin Power & Utilities's ROCE

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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.