Today we’ll look at Senetas Corporation Limited (ASX:SEN) and reflect on its potential as an investment. 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. Finally, we’ll look at how its current liabilities affect its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.’

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 Senetas:

0.11 = AU$2.9m ÷ (AU$36m – AU$9.9m) (Based on the trailing twelve months to June 2018.)

So, Senetas has an ROCE of 11%.

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Is Senetas’s ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that Senetas’s ROCE is meaningfully better than the 8.9% average in the Communications industry. I think that’s good to see, since it implies the company is better than other companies at making the most of its capital. Separate from Senetas’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

As we can see, Senetas currently has an ROCE of 11%, less than the 28% it reported 3 years ago. This makes us wonder if the business is facing new challenges.

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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Do Senetas’s Current Liabilities Skew Its 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 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Senetas has total assets of AU$36m and current liabilities of AU$9.9m. As a result, its current liabilities are equal to approximately 28% of its total assets. Low current liabilities are not boosting the ROCE too much.

Our Take On Senetas’s ROCE

With that in mind, Senetas’s ROCE appears pretty good. Of course you might be able to find a better stock than Senetas. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.