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Today we’ll evaluate Apiam Animal Health Limited (ASX:AHX) to determine whether it could have potential as an investment idea. To be precise, we’ll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

First, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. Then we’ll determine how its current liabilities are affecting 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. 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 Apiam Animal Health:

0.074 = AU$6.2m ÷ (AU$105m – AU$21m) (Based on the trailing twelve months to June 2018.)

So, Apiam Animal Health has an ROCE of 7.4%.

See our latest analysis for Apiam Animal Health

Does Apiam Animal Health Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Apiam Animal Health’s ROCE appears meaningfully below the 11% average reported by the Healthcare industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Setting aside the industry comparison for now, Apiam Animal Health’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.

Apiam Animal Health reported an ROCE of 7.4% — better than 3 years ago, when the company didn’t make a profit. This makes us wonder if the company is improving.

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 deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Apiam Animal Health.

Do Apiam Animal Health’s Current Liabilities Skew 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.

Apiam Animal Health has total assets of AU$105m and current liabilities of AU$21m. As a result, its current liabilities are equal to approximately 20% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

What We Can Learn From Apiam Animal Health’s ROCE

If Apiam Animal Health continues to earn an uninspiring ROCE, there may be better places to invest. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

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

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.