Today we'll look at Gamma Communications plc (LON:GAMA) and reflect on its potential as an investment. Specifically, we'll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.
Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. All else being equal, a better business will have a higher ROCE. 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.
So, How Do We Calculate ROCE?
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 Gamma Communications:
0.26 = UK£41m ÷ (UK£221m - UK£62m) (Based on the trailing twelve months to June 2019.)
Therefore, Gamma Communications has an ROCE of 26%.
Is Gamma Communications's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Gamma Communications's ROCE is meaningfully better than the 8.4% average in the Telecom industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Setting aside the comparison to its industry for a moment, Gamma Communications's ROCE in absolute terms currently looks quite high.
The image below shows how Gamma Communications's ROCE compares to its industry, and you can click it to see more detail on its past growth.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Gamma Communications.
What Are Current Liabilities, And How Do They Affect Gamma Communications's ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Gamma Communications has current liabilities of UK£62m and total assets of UK£221m. Therefore its current liabilities are equivalent to approximately 28% of its total assets. A minimal amount of current liabilities limits the impact on ROCE.
The Bottom Line On Gamma Communications's ROCE
With low current liabilities and a high ROCE, Gamma Communications could be worthy of further investigation. There might be better investments than Gamma Communications 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.
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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.
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