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Here’s why The Cato Corporation’s (NYSE:CATO) Returns On Capital Matters So Much

Simply Wall St

Today we'll look at The Cato Corporation (NYSE:CATO) 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. 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. 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'.

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 Cato:

0.083 = US$30m ÷ (US$498m - US$141m) (Based on the trailing twelve months to February 2019.)

So, Cato has an ROCE of 8.3%.

See our latest analysis for Cato

Does Cato Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Cato's ROCE appears meaningfully below the 14% average reported by the Specialty Retail industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how Cato stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.

Cato's current ROCE of 8.3% is lower than its ROCE in the past, which was 21%, 3 years ago. Therefore we wonder if the company is facing new headwinds.

NYSE:CATO Past Revenue and Net Income, April 23rd 2019

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. How cyclical is Cato? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

Do Cato's Current Liabilities Skew Its ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Cato has total liabilities of US$141m and total assets of US$498m. As a result, its current liabilities are equal to approximately 28% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

The Bottom Line On Cato's ROCE

With that in mind, we're not overly impressed with Cato's ROCE, so it may not be the most appealing prospect. 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.

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.