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Don’t Buy Wellington Drive Technologies Limited (NZSE:WDT) Until You Understand Its ROCE

Simply Wall St

Today we'll look at Wellington Drive Technologies Limited (NZSE:WDT) and reflect on its potential as an investment. 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. Then we'll determine how its current liabilities are affecting 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. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.

How Do You Calculate Return On Capital Employed?

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 Wellington Drive Technologies:

0.16 = NZ$2.0m ÷ (NZ$40m - NZ$28m) (Based on the trailing twelve months to June 2019.)

So, Wellington Drive Technologies has an ROCE of 16%.

Check out our latest analysis for Wellington Drive Technologies

Does Wellington Drive Technologies Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. It appears that Wellington Drive Technologies's ROCE is fairly close to the Electrical industry average of 15%. Independently of how Wellington Drive Technologies compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

Wellington Drive Technologies has an ROCE of 16%, but it didn't have an ROCE 3 years ago, since it was unprofitable. That suggests the business has returned to profitability. You can click on the image below to see (in greater detail) how Wellington Drive Technologies's past growth compares to other companies.

NZSE:WDT Past Revenue and Net Income, December 21st 2019

When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. ROCE is only a point-in-time measure. How cyclical is Wellington Drive Technologies? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

Do Wellington Drive Technologies'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 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.

Wellington Drive Technologies has total assets of NZ$40m and current liabilities of NZ$28m. Therefore its current liabilities are equivalent to approximately 69% of its total assets. Wellington Drive Technologies's current liabilities are fairly high, which increases its ROCE significantly.

The Bottom Line On Wellington Drive Technologies's ROCE

While its ROCE looks decent, it wouldn't look so good if it reduced current liabilities. Wellington Drive Technologies 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.

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.