Today we'll look at Action Construction Equipment Limited (NSE:ACE) 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. Finally, we'll look at how its current liabilities affect 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. In brief, it is a useful tool, but it is not without drawbacks. 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?
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 Action Construction Equipment:
0.18 = ₹871m ÷ (₹8.9b - ₹3.9b) (Based on the trailing twelve months to March 2019.)
Therefore, Action Construction Equipment has an ROCE of 18%.
Is Action Construction Equipment's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Action Construction Equipment's ROCE is meaningfully higher than the 13% average in the Machinery industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how Action Construction Equipment compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
In our analysis, Action Construction Equipment's ROCE appears to be 18%, compared to 3 years ago, when its ROCE was 6.1%. This makes us think about whether the company has been reinvesting shrewdly. You can see in the image below how Action Construction Equipment's ROCE compares to its industry. Click to see more on past growth.
When considering this metric, keep in mind that it is backwards looking, and 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, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
What Are Current Liabilities, And How Do They Affect Action Construction Equipment's 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.
Action Construction Equipment has total assets of ₹8.9b and current liabilities of ₹3.9b. As a result, its current liabilities are equal to approximately 44% of its total assets. Action Construction Equipment has a middling amount of current liabilities, increasing its ROCE somewhat.
The Bottom Line On Action Construction Equipment's ROCE
With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. Action Construction Equipment 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.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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 firstname.lastname@example.org. 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.