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What Can We Make Of CMI Limited’s (NSE:CMI) High Return On Capital?

Simply Wall St

Today we'll evaluate CMI Limited (NSE:CMI) to determine whether it could have potential as an investment idea. 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, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.

What is Return On Capital Employed (ROCE)?

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. 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'.

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 CMI:

0.18 = ₹672m ÷ (₹7.2b - ₹3.5b) (Based on the trailing twelve months to June 2019.)

Therefore, CMI has an ROCE of 18%.

Check out our latest analysis for CMI

Is CMI's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. CMI's ROCE appears to be substantially greater than the 13% average in the Electrical industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of where CMI sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

You can see in the image below how CMI's ROCE compares to its industry. Click to see more on past growth.

NSEI:CMI Past Revenue and Net Income, October 5th 2019

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

How CMI'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 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.

CMI has total assets of ₹7.2b and current liabilities of ₹3.5b. As a result, its current liabilities are equal to approximately 49% of its total assets. CMI has a medium level of current liabilities, which would boost the ROCE.

What We Can Learn From CMI's ROCE

While its ROCE looks good, it's worth remembering that the current liabilities are making the business look better. CMI 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 editorial-team@simplywallst.com. 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.