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Why The New Zealand Refining Company Limited’s (NZSE:NZR) Return On Capital Employed Might Be A Concern

Simply Wall St

Today we'll look at The New Zealand Refining Company Limited (NZSE:NZR) and reflect on its potential as an investment. 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. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested 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'.

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 New Zealand Refining:

0.047 = NZ$54m ÷ (NZ$1.4b - NZ$226m) (Based on the trailing twelve months to June 2019.)

Therefore, New Zealand Refining has an ROCE of 4.7%.

Check out our latest analysis for New Zealand Refining

Is New Zealand Refining's ROCE Good?

One way to assess ROCE is to compare similar companies. Using our data, New Zealand Refining's ROCE appears to be significantly below the 10.0% average in the Oil and Gas industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Setting aside the industry comparison for now, New Zealand Refining's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

New Zealand Refining's current ROCE of 4.7% is lower than its ROCE in the past, which was 14%, 3 years ago. Therefore we wonder if the company is facing new headwinds. You can click on the image below to see (in greater detail) how New Zealand Refining's past growth compares to other companies.

NZSE:NZR Past Revenue and Net Income, February 9th 2020

It is important to remember that ROCE shows past performance, and is 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. Remember that most companies like New Zealand Refining are cyclical businesses. Since the future is so important for investors, you should check out our free report on analyst forecasts for New Zealand Refining.

Do New Zealand Refining's Current Liabilities Skew 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. 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.

New Zealand Refining has total assets of NZ$1.4b and current liabilities of NZ$226m. As a result, its current liabilities are equal to approximately 16% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

Our Take On New Zealand Refining's ROCE

With that in mind, we're not overly impressed with New Zealand Refining's ROCE, so it may not be the most appealing prospect. You might be able to find a better investment than New Zealand Refining. 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).

I will like New Zealand Refining better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider 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.