Today we'll evaluate Graham Corporation (NYSE:GHM) to determine whether it could have potential as an investment idea. 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. Then we'll determine how its current liabilities are affecting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its 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.'
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 Graham:
0.04 = US$4.3m ÷ (US$157m - US$49m) (Based on the trailing twelve months to December 2018.)
Therefore, Graham has an ROCE of 4.0%.
Does Graham Have A Good ROCE?
One way to assess ROCE is to compare similar companies. We can see Graham's ROCE is meaningfully below the Machinery industry average of 11%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Putting aside Graham's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. Readers may wish to look for more rewarding investments.
As we can see, Graham currently has an ROCE of 4.0%, less than the 11% it reported 3 years ago. This makes us wonder if the business is facing new challenges.
Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately 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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Graham.
How Graham's Current Liabilities Impact 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. 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.
Graham has total assets of US$157m and current liabilities of US$49m. As a result, its current liabilities are equal to approximately 31% of its total assets. In light of sufficient current liabilities to noticeably boost the ROCE, Graham's ROCE is concerning.
Our Take On Graham's ROCE
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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.