Today we'll look at Engenco Limited (ASX:EGN) 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, 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.
What is Return On Capital Employed (ROCE)?
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. Overall, it is a valuable metric that has its flaws. 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 Engenco:
0.12 = AU$10m ÷ (AU$112m - AU$27m) (Based on the trailing twelve months to June 2019.)
So, Engenco has an ROCE of 12%.
Does Engenco Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. Engenco's ROCE appears to be substantially greater than the 8.0% average in the Machinery industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of where Engenco sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
In our analysis, Engenco's ROCE appears to be 12%, compared to 3 years ago, when its ROCE was 6.0%. This makes us think the business might be improving. The image below shows how Engenco's ROCE compares to its industry, and you can click it to see more detail on its 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. If Engenco is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
How Engenco'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 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.
Engenco has total liabilities of AU$27m and total assets of AU$112m. Therefore its current liabilities are equivalent to approximately 24% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
Our Take On Engenco's ROCE
With that in mind, Engenco's ROCE appears pretty good. Engenco 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.
I will like Engenco better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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