Today we are going to look at Hammond Manufacturing Company Limited (TSE:HMM.A) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into 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.
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. Ultimately, it is a useful but imperfect metric. 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'.
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 Hammond Manufacturing:
0.12 = CA$8.2m ÷ (CA$112m - CA$44m) (Based on the trailing twelve months to June 2019.)
So, Hammond Manufacturing has an ROCE of 12%.
Does Hammond Manufacturing Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. We can see Hammond Manufacturing's ROCE is around the 11% average reported by the Electrical industry. Separate from Hammond Manufacturing's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
Our data shows that Hammond Manufacturing currently has an ROCE of 12%, compared to its ROCE of 9.6% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly. You can click on the image below to see (in greater detail) how Hammond Manufacturing's past growth compares to other companies.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. If Hammond Manufacturing 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 Hammond Manufacturing'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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Hammond Manufacturing has total liabilities of CA$44m and total assets of CA$112m. Therefore its current liabilities are equivalent to approximately 39% of its total assets. Hammond Manufacturing has a medium level of current liabilities, which would boost the ROCE.
Our Take On Hammond Manufacturing's ROCE
With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. There might be better investments than Hammond Manufacturing 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.