Today we'll evaluate Praemium Limited (ASX:PPS) to determine whether it could have potential as an investment idea. 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. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.

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 Praemium:

0.27 = AU$8.2m ÷ (AU$45m - AU$15m) (Based on the trailing twelve months to December 2019.)

So, Praemium has an ROCE of 27%.

Check out our latest analysis for Praemium

Does Praemium Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Praemium's ROCE is meaningfully higher than the 17% average in the Software 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. Putting aside its position relative to its industry for now, in absolute terms, Praemium's ROCE is currently very good.

In our analysis, Praemium's ROCE appears to be 27%, compared to 3 years ago, when its ROCE was 21%. This makes us think the business might be improving. You can see in the image below how Praemium'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. 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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Praemium.

How Praemium's Current Liabilities Impact Its ROCE

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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.

Praemium has total assets of AU$45m and current liabilities of AU$15m. Therefore its current liabilities are equivalent to approximately 33% of its total assets. Praemium has a medium level of current liabilities, boosting its ROCE somewhat.

Our Take On Praemium's ROCE

Despite this, it reports a high ROCE, and may be worth investigating further. Praemium 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).

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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.