Today we'll look at 1300SMILES Limited (ASX:ONT) 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 of all, we'll work out how to calculate ROCE. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

Return On Capital Employed (ROCE): What is it?

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. 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'.

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 1300SMILES:

0.16 = AU$9.7m ÷ (AU$70m - AU$8.4m) (Based on the trailing twelve months to December 2019.)

Therefore, 1300SMILES has an ROCE of 16%.

View our latest analysis for 1300SMILES

Does 1300SMILES Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. In our analysis, 1300SMILES's ROCE is meaningfully higher than the 8.8% average in the Healthcare industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how 1300SMILES compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

1300SMILES's current ROCE of 16% is lower than 3 years ago, when the company reported a 29% ROCE. This makes us wonder if the business is facing new challenges. You can see in the image below how 1300SMILES's ROCE compares to its industry. Click to see more on past growth.

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for 1300SMILES.

What Are Current Liabilities, And How Do They Affect 1300SMILES'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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.