Today we'll look at Engenco Limited (ASX:EGN) and reflect on its potential as an investment. 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. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
Understanding 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. In brief, it is a useful tool, but it is not without drawbacks. 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 Engenco:
0.16 = AU$12m ÷ (AU$102m - AU$24m) (Based on the trailing twelve months to December 2018.)
So, Engenco has an ROCE of 16%.
Does Engenco Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Engenco's ROCE is meaningfully higher than the 7.7% average in the Machinery industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how Engenco compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
Engenco has an ROCE of 16%, but it didn't have an ROCE 3 years ago, since it was unprofitable. This makes us wonder if the company is improving. You can see in the image below how Engenco's ROCE compares to its industry. Click to see more on 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. ROCE is, after all, simply a snap shot of a single year. If Engenco is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect Engenco'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. 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.
Engenco has total assets of AU$102m and current liabilities of AU$24m. As a result, its current liabilities are equal to approximately 23% of its total assets. Low current liabilities are not boosting the ROCE too much.
Our Take On Engenco's ROCE
This is good to see, and with a sound ROCE, Engenco could be worth a closer look. There might be better investments than Engenco 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.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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If you spot an error that warrants correction, please contact the editor at email@example.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.