U.S. Markets closed

Here’s why RADA Electronic Industries Ltd.’s (NASDAQ:RADA) Returns On Capital Matters So Much

Simply Wall St

Today we’ll evaluate RADA Electronic Industries Ltd. (NASDAQ:RADA) to determine whether it could have potential as an investment idea. 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 of all, we’ll work out how to calculate ROCE. 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 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’.

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 RADA Electronic Industries:

0.0087 = US$2.0m ÷ (US$38m – US$7.3m) (Based on the trailing twelve months to September 2018.)

Therefore, RADA Electronic Industries has an ROCE of 0.9%.

See our latest analysis for RADA Electronic Industries

Does RADA Electronic Industries Have A Good ROCE?

One way to assess ROCE is to compare similar companies. We can see RADA Electronic Industries’s ROCE is meaningfully below the Aerospace & Defense industry average of 11%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Independently of how RADA Electronic Industries compares to its industry, its ROCE in absolute terms is low; especially compared to the ~2.7% available in government bonds. There are potentially more appealing investments elsewhere.

RADA Electronic Industries has an ROCE of 0.9%, but it didn’t have an ROCE 3 years ago, since it was unprofitable. That implies the business has been improving.

NasdaqCM:RADA Past Revenue and Net Income, February 28th 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 misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is, after all, simply a snap shot of a single year. 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 RADA Electronic Industries’s 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 counter this, investors can check if a company has high current liabilities relative to total assets.

RADA Electronic Industries has total liabilities of US$7.3m and total assets of US$38m. Therefore its current liabilities are equivalent to approximately 19% of its total assets. With a very reasonable level of current liabilities, so the impact on ROCE is fairly minimal.

The Bottom Line On RADA Electronic Industries’s ROCE

While that is good to see, RADA Electronic Industries has a low ROCE and does not look attractive in this analysis. You might be able to find a better buy than RADA Electronic Industries. 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.