Today we'll evaluate ARB Corporation Limited (ASX:ARB) 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.
Firstly, we'll go over how we calculate ROCE. 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. Generally speaking a higher ROCE is better. In brief, it is a useful tool, but it is not without drawbacks. 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?
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 ARB:
0.22 = AU$77m ÷ (AU$399m - AU$51m) (Based on the trailing twelve months to June 2019.)
Therefore, ARB has an ROCE of 22%.
Is ARB's ROCE Good?
One way to assess ROCE is to compare similar companies. It appears that ARB's ROCE is fairly close to the Auto Components industry average of 27%. Regardless of the industry comparison, in absolute terms, ARB's ROCE currently appears to be excellent.
You can see in the image below how ARB'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. 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 only a point-in-time measure. Since the future is so important for investors, you should check out our free report on analyst forecasts for ARB.
Do ARB's Current Liabilities Skew Its 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
ARB has total liabilities of AU$51m and total assets of AU$399m. Therefore its current liabilities are equivalent to approximately 13% of its total assets. A minimal amount of current liabilities limits the impact on ROCE.
Our Take On ARB's ROCE
Low current liabilities and high ROCE is a good combination, making ARB look quite interesting. There might be better investments than ARB out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
I will like ARB better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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.