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Why You Should Care About Costa Group Holdings Limited’s (ASX:CGC) Low Return On Capital

Simply Wall St

Today we'll look at Costa Group Holdings Limited (ASX:CGC) 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 of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. 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 Costa Group Holdings:

0.016 = AU$18m ÷ (AU$1.3b - AU$223m) (Based on the trailing twelve months to June 2019.)

So, Costa Group Holdings has an ROCE of 1.6%.

Check out our latest analysis for Costa Group Holdings

Does Costa Group Holdings Have A Good ROCE?

One way to assess ROCE is to compare similar companies. Using our data, Costa Group Holdings's ROCE appears to be significantly below the 7.1% average in the Food industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Putting aside Costa Group Holdings's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. It is likely that there are more attractive prospects out there.

Costa Group Holdings's current ROCE of 1.6% is lower than its ROCE in the past, which was 7.6%, 3 years ago. This makes us wonder if the business is facing new challenges. The image below shows how Costa Group Holdings's ROCE compares to its industry, and you can click it to see more detail on its past growth.

ASX:CGC Past Revenue and Net Income, October 23rd 2019

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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 only a point-in-time measure. Since the future is so important for investors, you should check out our free report on analyst forecasts for Costa Group Holdings.

Do Costa Group Holdings's Current Liabilities Skew Its ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.

Costa Group Holdings has total assets of AU$1.3b and current liabilities of AU$223m. As a result, its current liabilities are equal to approximately 17% of its total assets. With a very reasonable level of current liabilities, so the impact on ROCE is fairly minimal.

The Bottom Line On Costa Group Holdings's ROCE

Costa Group Holdings has a poor ROCE, and there may be better investment prospects 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).

Costa Group Holdings is not the only stock that insiders are buying. For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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 editorial-team@simplywallst.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.