Today we'll look at Orica Limited (ASX:ORI) and reflect on its potential as an investment. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its 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.
Return On Capital Employed (ROCE): What is it?
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 Orica:
0.10 = AU$594m ÷ (AU$7.3b - AU$1.6b) (Based on the trailing twelve months to September 2019.)
Therefore, Orica has an ROCE of 10%.
Is Orica's ROCE Good?
One way to assess ROCE is to compare similar companies. In our analysis, Orica's ROCE is meaningfully higher than the 8.0% average in the Chemicals 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. Regardless of where Orica sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
The image below shows how Orica's ROCE compares to its industry, and you can click it to see more detail on its past growth.
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, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
What Are Current Liabilities, And How Do They Affect Orica's ROCE?
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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.
Orica has current liabilities of AU$1.6b and total assets of AU$7.3b. Therefore its current liabilities are equivalent to approximately 22% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
What We Can Learn From Orica's ROCE
With that in mind, Orica's ROCE appears pretty good. Orica shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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.
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