Today we'll evaluate Whitehaven Coal Limited (ASX:WHC) to determine whether it could have potential as an investment idea. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed 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 Whitehaven Coal:

0.084 = AU$392m ÷ (AU$5.0b - AU$334m) (Based on the trailing twelve months to December 2019.)

Therefore, Whitehaven Coal has an ROCE of 8.4%.

Check out our latest analysis for Whitehaven Coal

Is Whitehaven Coal's ROCE Good?

One way to assess ROCE is to compare similar companies. In our analysis, Whitehaven Coal's ROCE is meaningfully higher than the 6.6% average in the Oil and Gas industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Separate from how Whitehaven Coal stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Readers may find more attractive investment prospects elsewhere.

You can click on the image below to see (in greater detail) how Whitehaven Coal's past growth compares to other companies.

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. We note Whitehaven Coal could be considered a cyclical business. Since the future is so important for investors, you should check out our free report on analyst forecasts for Whitehaven Coal.

Whitehaven Coal's Current Liabilities And Their Impact On Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.

Whitehaven Coal has total assets of AU$5.0b and current liabilities of AU$334m. As a result, its current liabilities are equal to approximately 6.6% of its total assets. Whitehaven Coal has a low level of current liabilities, which have a minimal impact on its uninspiring ROCE.

What We Can Learn From Whitehaven Coal's ROCE

Based on this information, Whitehaven Coal appears to be a mediocre business. 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.

Whitehaven Coal is not the only stock insiders are buying. So take a peek at this free list of growing companies with 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.