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Why You Should Care About Nuance Communications, Inc.’s (NASDAQ:NUAN) Low Return On Capital

Simply Wall St

Today we'll look at Nuance Communications, Inc. (NASDAQ:NUAN) and reflect on its potential as an investment. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First up, we'll look at what ROCE is and how we calculate it. 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 measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. 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 Nuance Communications:

0.063 = US$222m ÷ (US$5.4b - US$1.8b) (Based on the trailing twelve months to September 2019.)

Therefore, Nuance Communications has an ROCE of 6.3%.

View our latest analysis for Nuance Communications

Does Nuance Communications Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. We can see Nuance Communications's ROCE is meaningfully below the Software industry average of 9.8%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Setting aside the industry comparison for now, Nuance Communications's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.

Our data shows that Nuance Communications currently has an ROCE of 6.3%, compared to its ROCE of 3.6% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly. You can see in the image below how Nuance Communications's ROCE compares to its industry. Click to see more on past growth.

NasdaqGS:NUAN Past Revenue and Net Income, January 6th 2020

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. 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.

How Nuance Communications's Current Liabilities Impact 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 ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Nuance Communications has total assets of US$5.4b and current liabilities of US$1.8b. Therefore its current liabilities are equivalent to approximately 34% of its total assets. Nuance Communications's middling level of current liabilities have the effect of boosting its ROCE a bit.

Our Take On Nuance Communications's ROCE

Despite this, its ROCE is still mediocre, and you may find more appealing investments elsewhere. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

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.