In This Article:
Today we'll evaluate Sonata Software Limited (NSE:SONATSOFTW) 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 up, we'll look at what ROCE is and how we calculate it. Second, we'll look at its ROCE compared to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
What is Return On Capital Employed (ROCE)?
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?
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 Sonata Software:
0.41 = ₹3.3b ÷ (₹15b - ₹7.2b) (Based on the trailing twelve months to June 2019.)
Therefore, Sonata Software has an ROCE of 41%.
View our latest analysis for Sonata Software
Is Sonata Software's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that Sonata Software's ROCE is meaningfully better than the 14% average in the IT industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Setting aside the comparison to its industry for a moment, Sonata Software's ROCE in absolute terms currently looks quite high.
You can see in the image below how Sonata Software's ROCE compares to its industry. Click to see more on past growth.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Sonata Software.
How Sonata Software's Current Liabilities Impact Its ROCE
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.