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Why You Should Care About Western Areas Limited’s (ASX:WSA) Low Return On Capital

Simply Wall St

Today we are going to look at Western Areas Limited (ASX:WSA) to see whether it might be an attractive investment prospect. 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. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.

Understanding 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. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.

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:

0.018 = AU$10m ÷ (AU$597m - AU$53m) (Based on the trailing twelve months to June 2019.)

So, Western Areas has an ROCE of 1.8%.

Check out our latest analysis for Western Areas

Does Western Areas Have A Good ROCE?

One way to assess ROCE is to compare similar companies. Using our data, Western Areas's ROCE appears to be significantly below the 7.9% average in the Metals and Mining industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Independently of how Western Areas compares to its industry, its ROCE in absolute terms is low; especially compared to the ~2.3% available in government bonds. There are potentially more appealing investments elsewhere.

Western Areas reported an ROCE of 1.8% -- better than 3 years ago, when the company didn't make a profit. That implies the business has been improving. The image below shows how Western Areas's ROCE compares to its industry, and you can click it to see more detail on its past growth.

ASX:WSA Past Revenue and Net Income, October 16th 2019

When considering ROCE, bear in mind that it reflects the past and does not necessarily 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, after all, simply a snap shot of a single year. We note Western Areas could be considered a cyclical business. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Do Western Areas's Current Liabilities Skew Its ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Western Areas has total liabilities of AU$53m and total assets of AU$597m. As a result, its current liabilities are equal to approximately 9.0% of its total assets. Western Areas has a low level of current liabilities, which have a negligible impact on its already low ROCE.

What We Can Learn From Western Areas's ROCE

Nonetheless, there may be better places to invest your capital. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

I will like Western Areas better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

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.