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Is The Eastern Company's (NASDAQ:EML) Capital Allocation Ability Worth Your Time?

Simply Wall St

Today we'll evaluate The Eastern Company (NASDAQ:EML) to determine whether it could have potential as an investment idea. 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.

Understanding Return On Capital Employed (ROCE)

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. 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.

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 Eastern:

0.12 = US$18m ÷ (US$185m - US$28m) (Based on the trailing twelve months to June 2019.)

So, Eastern has an ROCE of 12%.

See our latest analysis for Eastern

Does Eastern Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. It appears that Eastern's ROCE is fairly close to the Machinery industry average of 11%. Independently of how Eastern compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

We can see that, Eastern currently has an ROCE of 12% compared to its ROCE 3 years ago, which was 9.0%. This makes us think about whether the company has been reinvesting shrewdly. The image below shows how Eastern's ROCE compares to its industry, and you can click it to see more detail on its past growth.

NasdaqGM:EML Past Revenue and Net Income, November 6th 2019
NasdaqGM:EML Past Revenue and Net Income, November 6th 2019

When considering this metric, keep in mind that it is backwards looking, and 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. How cyclical is Eastern? 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 Eastern's ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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.

Eastern has total liabilities of US$28m and total assets of US$185m. As a result, its current liabilities are equal to approximately 15% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.

What We Can Learn From Eastern's ROCE

With that in mind, Eastern's ROCE appears pretty good. There might be better investments than Eastern out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.

There are plenty of other companies that have insiders buying up shares. You probably do not want to miss this free list of growing companies that insiders are buying.

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.