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Today we’ll look at Northern Star Resources Limited (ASX:NST) and reflect on its potential as an investment. 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, 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 measures the ‘return’ (pre-tax profit) a company generates from capital employed in its business. All else being equal, a better business will have a higher ROCE. 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?

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 Northern Star Resources:

0.21 = AU$275m ÷ (AU$1.6b – AU$219m) (Based on the trailing twelve months to December 2018.)

Therefore, Northern Star Resources has an ROCE of 21%.

View our latest analysis for Northern Star Resources

Does Northern Star Resources Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Northern Star Resources’s ROCE is meaningfully higher than the 11% average in the Metals and Mining industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Putting aside its position relative to its industry for now, in absolute terms, Northern Star Resources’s ROCE is currently very good.

Northern Star Resources’s current ROCE of 21% is lower than its ROCE in the past, which was 40%, 3 years ago. So investors might consider if it has had issues recently.

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Remember that most companies like Northern Star Resources are cyclical businesses. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Northern Star Resources.

What Are Current Liabilities, And How Do They Affect Northern Star Resources’s ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Northern Star Resources has total liabilities of AU$219m and total assets of AU$1.6b. Therefore its current liabilities are equivalent to approximately 14% of its total assets. This is quite a low level of current liabilities which would not greatly boost the already high ROCE.

What We Can Learn From Northern Star Resources’s ROCE

This is good to see, and with such a high ROCE, Northern Star Resources may be worth a closer look. 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 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.