Today we'll look at Red River Resources Limited (ASX:RVR) 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.
Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
What is 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. All else being equal, a better business will have a higher ROCE. 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?
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 Red River Resources:
0.083 = AU$5.3m ÷ (AU$82m - AU$18m) (Based on the trailing twelve months to June 2019.)
Therefore, Red River Resources has an ROCE of 8.3%.
Is Red River Resources's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. It appears that Red River Resources's ROCE is fairly close to the Metals and Mining industry average of 7.9%. Aside from the industry comparison, Red River Resources's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.
Red River Resources reported an ROCE of 8.3% -- better than 3 years ago, when the company didn't make a profit. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how Red River Resources's past growth compares to other companies.
When considering ROCE, bear in mind that it reflects the past and does not necessarily 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 only a point-in-time measure. Remember that most companies like Red River Resources are cyclical businesses. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
How Red River Resources's Current Liabilities Impact 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. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Red River Resources has total assets of AU$82m and current liabilities of AU$18m. As a result, its current liabilities are equal to approximately 22% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
Our Take On Red River Resources's ROCE
If Red River Resources continues to earn an uninspiring ROCE, there may be better places to invest. Of course, you might also be able to find a better stock than Red River Resources. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 firstname.lastname@example.org. 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.