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Why You Should Care About K-Bro Linen Inc.’s (TSE:KBL) Low Return On Capital

Simply Wall St

Today we'll evaluate K-Bro Linen Inc. (TSE:KBL) to determine whether it could have potential as an investment idea. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First of all, we'll work out how to calculate ROCE. 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. 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 K-Bro Linen:

0.038 = CA$12m ÷ (CA$361m - CA$39m) (Based on the trailing twelve months to June 2019.)

Therefore, K-Bro Linen has an ROCE of 3.8%.

View our latest analysis for K-Bro Linen

Is K-Bro Linen's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. In this analysis, K-Bro Linen's ROCE appears meaningfully below the 7.9% average reported by the Commercial Services industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Independently of how K-Bro Linen compares to its industry, its ROCE in absolute terms is low; especially compared to the ~1.9% available in government bonds. It is likely that there are more attractive prospects out there.

We can see that, K-Bro Linen currently has an ROCE of 3.8%, less than the 13% 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 K-Bro Linen's past growth compares to other companies.

TSX:KBL Past Revenue and Net Income, November 8th 2019

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. ROCE is, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Do K-Bro Linen's Current Liabilities Skew 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.

K-Bro Linen has total assets of CA$361m and current liabilities of CA$39m. Therefore its current liabilities are equivalent to approximately 11% of its total assets. This is not a high level of current liabilities, which would not boost the ROCE by much.

The Bottom Line On K-Bro Linen's ROCE

While that is good to see, K-Bro Linen has a low ROCE and does not look attractive in this analysis. 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).

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.