Today we'll look at EML Payments Limited (ASX:EML) and reflect on its potential as an investment. 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 up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

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

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested 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?

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 EML Payments:

0.077 = AU$14m ÷ (AU$477m - AU$299m) (Based on the trailing twelve months to June 2019.)

So, EML Payments has an ROCE of 7.7%.

See our latest analysis for EML Payments

Does EML Payments Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, EML Payments's ROCE appears to be significantly below the 15% average in the IT industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Aside from the industry comparison, EML Payments's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

EML Payments delivered an ROCE of 7.7%, which is better than 3 years ago, as was making losses back then. That suggests the business has returned to profitability. You can click on the image below to see (in greater detail) how EML Payments'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. Since the future is so important for investors, you should check out our free report on analyst forecasts for EML Payments.

What Are Current Liabilities, And How Do They Affect EML Payments'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. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counteract this, we check if a company has high current liabilities, relative to its total assets.

EML Payments has current liabilities of AU$299m and total assets of AU$477m. Therefore its current liabilities are equivalent to approximately 63% of its total assets. With a high level of current liabilities, EML Payments will experience a boost to its ROCE.

Our Take On EML Payments's ROCE

Despite this, the company also has a uninspiring ROCE, which is not an ideal combination in this analysis. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

EML Payments 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.