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Here’s What The Colonial Motor Company Limited’s (NZSE:CMO) Return On Capital Can Tell Us

Simply Wall St

Today we are going to look at The Colonial Motor Company Limited (NZSE:CMO) to see whether it might be an attractive investment prospect. 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 up, we'll look at what ROCE is and how we calculate it. 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 measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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?

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 Colonial Motor:

0.18 = NZ$39m ÷ (NZ$388m - NZ$169m) (Based on the trailing twelve months to June 2019.)

So, Colonial Motor has an ROCE of 18%.

Check out our latest analysis for Colonial Motor

Does Colonial Motor Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. We can see Colonial Motor's ROCE is around the 17% average reported by the Specialty Retail industry. Separate from Colonial Motor's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

The image below shows how Colonial Motor's ROCE compares to its industry, and you can click it to see more detail on its past growth.

NZSE:CMO Past Revenue and Net Income, January 1st 2020

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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. How cyclical is Colonial Motor? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect Colonial Motor'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. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Colonial Motor has total liabilities of NZ$169m and total assets of NZ$388m. Therefore its current liabilities are equivalent to approximately 44% of its total assets. With this level of current liabilities, Colonial Motor's ROCE is boosted somewhat.

The Bottom Line On Colonial Motor's ROCE

While its ROCE looks good, it's worth remembering that the current liabilities are making the business look better. Colonial Motor looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

I will like Colonial Motor better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

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.

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. Thank you for reading.