Today we'll look at GR Engineering Services Limited (ASX:GNG) 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, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its 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. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that 'one dollar invested in the company generates value of more than one dollar'.
How Do You Calculate Return On Capital Employed?
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 GR Engineering Services:
0.18 = AU$8.4m ÷ (AU$82m - AU$34m) (Based on the trailing twelve months to June 2019.)
Therefore, GR Engineering Services has an ROCE of 18%.
Is GR Engineering Services's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that GR Engineering Services's ROCE is meaningfully better than the 7.8% average in the Metals and Mining industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Independently of how GR Engineering Services compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
GR Engineering Services's current ROCE of 18% is lower than its ROCE in the past, which was 40%, 3 years ago. This makes us wonder if the business is facing new challenges. You can see in the image below how GR Engineering Services's ROCE compares to its industry. Click to see more on past growth.
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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Remember that most companies like GR Engineering Services are cyclical businesses. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for GR Engineering Services.
What Are Current Liabilities, And How Do They Affect GR Engineering Services'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.
GR Engineering Services has total assets of AU$82m and current liabilities of AU$34m. As a result, its current liabilities are equal to approximately 41% of its total assets. GR Engineering Services has a medium level of current liabilities, which would boost the ROCE.
The Bottom Line On GR Engineering Services's ROCE
While its ROCE looks good, it's worth remembering that the current liabilities are making the business look better. GR Engineering Services shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
I will like GR Engineering Services better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider 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 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.