Today we'll look at Cirrus Networks Holdings Limited (ASX:CNW) 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 of all, we'll work out how to calculate ROCE. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed 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?
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 Cirrus Networks Holdings:
0.10 = AU$1.2m ÷ (AU$40m - AU$28m) (Based on the trailing twelve months to June 2019.)
So, Cirrus Networks Holdings has an ROCE of 10%.
Is Cirrus Networks Holdings's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. Using our data, Cirrus Networks Holdings's ROCE appears to be significantly below the 15% average in the IT industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Aside from the industry comparison, Cirrus Networks Holdings's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
Cirrus Networks Holdings reported an ROCE of 10% -- better than 3 years ago, when the company didn't make a profit. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how Cirrus Networks Holdings's past growth compares to other companies.
Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. 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 Cirrus Networks Holdings.
What Are Current Liabilities, And How Do They Affect Cirrus Networks Holdings'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. 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.
Cirrus Networks Holdings has total assets of AU$40m and current liabilities of AU$28m. Therefore its current liabilities are equivalent to approximately 69% of its total assets. With a high level of current liabilities, Cirrus Networks Holdings will experience a boost to its ROCE.
Our Take On Cirrus Networks Holdings's ROCE
Notably, it also has a mediocre ROCE, which to my mind is not an appealing combination. 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).
Cirrus Networks Holdings is not the only stock that insiders are buying. For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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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.