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Here’s why Granite Oil Corp.’s (TSE:GXO) Returns On Capital Matters So Much

Simply Wall St

Today we'll look at Granite Oil Corp. (TSE:GXO) 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.

Understanding 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. Generally speaking a higher ROCE is better. 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 Granite Oil:

0.02 = CA$4.5m ÷ (CA$277m - CA$51m) (Based on the trailing twelve months to December 2018.)

Therefore, Granite Oil has an ROCE of 2.0%.

View our latest analysis for Granite Oil

Does Granite Oil Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, Granite Oil's ROCE appears to be significantly below the 6.4% average in the Oil and Gas industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Putting aside Granite Oil'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.

Granite Oil's current ROCE of 2.0% is lower than 3 years ago, when the company reported a 5.2% ROCE. Therefore we wonder if the company is facing new headwinds.

TSX:GXO Past Revenue and Net Income, April 19th 2019

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. ROCE is, after all, simply a snap shot of a single year. Given the industry it operates in, Granite Oil could be considered cyclical. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

How Granite Oil's Current Liabilities Impact 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 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Granite Oil has total assets of CA$277m and current liabilities of CA$51m. As a result, its current liabilities are equal to approximately 18% of its total assets. With a very reasonable level of current liabilities, so the impact on ROCE is fairly minimal.

The Bottom Line On Granite Oil's ROCE

Granite Oil has a poor ROCE, and there may be better investment prospects out there. You might be able to find a better investment than Granite Oil. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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