Today we'll look at Electro Optic Systems Holdings Limited (ASX:EOS) 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.
First, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.
What is 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. Overall, it is a valuable metric that has its flaws. 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 Electro Optic Systems Holdings:
0.14 = AU$16m ÷ (AU$141m - AU$29m) (Based on the trailing twelve months to June 2019.)
Therefore, Electro Optic Systems Holdings has an ROCE of 14%.
Does Electro Optic Systems Holdings Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. Electro Optic Systems Holdings's ROCE appears to be substantially greater than the 9.4% average in the Aerospace & Defense 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. Separate from Electro Optic Systems Holdings's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
Electro Optic Systems Holdings's current ROCE of 14% is lower than 3 years ago, when the company reported a 31% ROCE. Therefore we wonder if the company is facing new headwinds. The image below shows how Electro Optic Systems Holdings'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. 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. How cyclical is Electro Optic Systems Holdings? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Electro Optic Systems Holdings's Current Liabilities And Their Impact On Its 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Electro Optic Systems Holdings has total assets of AU$141m and current liabilities of AU$29m. Therefore its current liabilities are equivalent to approximately 20% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
The Bottom Line On Electro Optic Systems Holdings's ROCE
With that in mind, Electro Optic Systems Holdings's ROCE appears pretty good. Electro Optic Systems Holdings 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.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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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