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Here’s why Orica Limited’s (ASX:ORI) Returns On Capital Matters So Much

Simply Wall St

Today we are going to look at Orica Limited (ASX:ORI) to see whether it might be an attractive investment prospect. 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.

Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE 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. 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'.

So, How Do We Calculate ROCE?

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 Orica:

0.10 = AU$590m ÷ (AU$7.2b - AU$1.5b) (Based on the trailing twelve months to March 2019.)

Therefore, Orica has an ROCE of 10%.

View our latest analysis for Orica

Is Orica's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Orica's ROCE appears meaningfully below the 13% average reported by the Chemicals industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Separate from Orica's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

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

ASX:ORI Past Revenue and Net Income, August 26th 2019

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately 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 only a point-in-time measure. Since the future is so important for investors, you should check out our free report on analyst forecasts for Orica.

Orica's Current Liabilities And Their Impact On Its ROCE

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Orica has total liabilities of AU$1.5b and total assets of AU$7.2b. As a result, its current liabilities are equal to approximately 21% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.

Our Take On Orica's ROCE

This is good to see, and with a sound ROCE, Orica could be worth a closer look. Orica looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

I will like Orica 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.