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Why IRESS Limited’s (ASX:IRE) Return On Capital Employed Looks Uninspiring

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Today we'll evaluate IRESS Limited (ASX:IRE) to determine whether it could have potential as an investment idea. 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. Second, we'll look at its ROCE compared to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. In general, businesses with a higher ROCE are usually better quality. 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?

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 IRESS:

0.15 = AU$95m ÷ (AU$696m - AU$58m) (Based on the trailing twelve months to December 2018.)

So, IRESS has an ROCE of 15%.

Check out our latest analysis for IRESS

Does IRESS Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. We can see IRESS's ROCE is meaningfully below the Software industry average of 19%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Regardless of where IRESS sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

You can click on the image below to see (in greater detail) how IRESS's past growth compares to other companies.

ASX:IRE Past Revenue and Net Income, July 12th 2019
ASX:IRE Past Revenue and Net Income, July 12th 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.

How IRESS's Current Liabilities Impact Its ROCE

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counter this, investors can check if a company has high current liabilities relative to total assets.

IRESS has total assets of AU$696m and current liabilities of AU$58m. As a result, its current liabilities are equal to approximately 8.3% of its total assets. Low current liabilities have only a minimal impact on IRESS's ROCE, making its decent returns more credible.

The Bottom Line On IRESS's ROCE

This is good to see, and while better prospects may exist, IRESS seems worth researching further. IRESS shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.

If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

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.

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