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Why Incitec Pivot Limited’s (ASX:IPL) Use Of Investor Capital Doesn’t Look Great

Simply Wall St

Today we are going to look at Incitec Pivot Limited (ASX:IPL) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the 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. Finally, we'll look at how its current liabilities affect 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. Overall, it is a valuable metric that has its flaws. 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 Incitec Pivot:

0.037 = AU$257m ÷ (AU$9.4b - AU$2.5b) (Based on the trailing twelve months to September 2019.)

Therefore, Incitec Pivot has an ROCE of 3.7%.

View our latest analysis for Incitec Pivot

Does Incitec Pivot Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, Incitec Pivot's ROCE appears to be significantly below the 8.0% average in the Chemicals industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Independently of how Incitec Pivot 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.

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

ASX:IPL Past Revenue and Net Income, December 5th 2019

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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 only a point-in-time measure. 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 Incitec Pivot's 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Incitec Pivot has total assets of AU$9.4b and current liabilities of AU$2.5b. Therefore its current liabilities are equivalent to approximately 27% of its total assets. This is a modest level of current liabilities, which will have a limited impact on the ROCE.

Our Take On Incitec Pivot's ROCE

Incitec Pivot has a poor ROCE, and there may be better investment prospects out there. Of course, you might also be able to find a better stock than Incitec Pivot. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.