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Why SolarWinds Corporation’s (NYSE:SWI) Return On Capital Employed Might Be A Concern

Simply Wall St

Today we'll evaluate SolarWinds Corporation (NYSE:SWI) 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.

Firstly, we'll go over how we 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.

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. Generally speaking a higher ROCE is better. 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'.

So, How Do We Calculate ROCE?

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 SolarWinds:

0.026 = US$124m ÷ (US$5.2b - US$375m) (Based on the trailing twelve months to March 2019.)

Therefore, SolarWinds has an ROCE of 2.6%.

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Is SolarWinds's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. Using our data, SolarWinds's ROCE appears to be significantly below the 9.7% average in the Software industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Regardless of how SolarWinds stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). Readers may wish to look for more rewarding investments.

SolarWinds has an ROCE of 2.6%, but it didn't have an ROCE 3 years ago, since it was unprofitable. That suggests the business has returned to profitability.

NYSE:SWI Past Revenue and Net Income, May 22nd 2019

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. 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 SolarWinds.

How SolarWinds's Current Liabilities Impact 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

SolarWinds has total liabilities of US$375m and total assets of US$5.2b. As a result, its current liabilities are equal to approximately 7.2% of its total assets. With barely any current liabilities, there is minimal impact on SolarWinds's admittedly low ROCE.

The Bottom Line On SolarWinds's ROCE

Nevertheless, there are potentially more attractive companies to invest in. You might be able to find a better investment than SolarWinds. 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).

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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.