Today we are going to look at Hindustan Composites Limited (NSE:HINDCOMPOS) 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.
Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Last but not least, we'll look at what impact its current liabilities have on 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. 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 Hindustan Composites:
0.02 = ₹159m ÷ (₹8.5b - ₹412m) (Based on the trailing twelve months to June 2019.)
Therefore, Hindustan Composites has an ROCE of 2.0%.
Does Hindustan Composites Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. We can see Hindustan Composites's ROCE is meaningfully below the Auto Components industry average of 14%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Regardless of how Hindustan Composites stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). There are potentially more appealing investments elsewhere.
We can see that, Hindustan Composites currently has an ROCE of 2.0%, less than the 4.3% it reported 3 years ago. So investors might consider if it has had issues recently. You can click on the image below to see (in greater detail) how Hindustan Composites'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 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. If Hindustan Composites is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
How Hindustan Composites'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. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counter this, investors can check if a company has high current liabilities relative to total assets.
Hindustan Composites has total liabilities of ₹412m and total assets of ₹8.5b. As a result, its current liabilities are equal to approximately 4.9% of its total assets. Hindustan Composites has a low level of current liabilities, which have a negligible impact on its already low ROCE.
What We Can Learn From Hindustan Composites's ROCE
Still, investors could probably find more attractive prospects with better performance out there. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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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.