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Why You Should Care About Roots Corporation’s (TSE:ROOT) Low Return On Capital

Today we'll evaluate Roots Corporation (TSE:ROOT) to determine whether it could have potential as an investment idea. 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. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting 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. Generally speaking a higher ROCE is better. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'

How Do You Calculate Return On Capital Employed?

Analysts use this formula to calculate return on capital employed:

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Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

Or for Roots:

0.052 = CA$23m ÷ (CA$514m - CA$68m) (Based on the trailing twelve months to May 2019.)

Therefore, Roots has an ROCE of 5.2%.

Check out our latest analysis for Roots

Is Roots's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. In this analysis, Roots's ROCE appears meaningfully below the 10% average reported by the Specialty Retail industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Separate from how Roots 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.

We can see that , Roots currently has an ROCE of 5.2% compared to its ROCE 3 years ago, which was 2.7%. This makes us think about whether the company has been reinvesting shrewdly. You can click on the image below to see (in greater detail) how Roots's past growth compares to other companies.

TSX:ROOT Past Revenue and Net Income, September 2nd 2019
TSX:ROOT Past Revenue and Net Income, September 2nd 2019

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.

How Roots'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. 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.

Roots has total liabilities of CA$68m and total assets of CA$514m. As a result, its current liabilities are equal to approximately 13% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

What We Can Learn From Roots's ROCE

If Roots continues to earn an uninspiring ROCE, there may be better places to invest. You might be able to find a better investment than Roots. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

I will like Roots better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider 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.