U.S. Markets open in 2 hrs 31 mins

Why You Should Care About Linamar Corporation’s (TSE:LNR) Low Return On Capital

Simply Wall St

Today we'll look at Linamar Corporation (TSE:LNR) and reflect on its potential as an investment. 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 up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its 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 Linamar:

0.12 = CA$785m ÷ (CA$8.4b - CA$1.7b) (Based on the trailing twelve months to March 2019.)

So, Linamar has an ROCE of 12%.

Check out our latest analysis for Linamar

Is Linamar's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. We can see Linamar's ROCE is meaningfully below the Auto Components industry average of 15%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Separate from Linamar's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

The image below shows how Linamar's ROCE compares to its industry, and you can click it to see more detail on its past growth.

TSX:LNR Past Revenue and Net Income, August 4th 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 only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Linamar's Current Liabilities And Their Impact On Its ROCE

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

Linamar has total assets of CA$8.4b and current liabilities of CA$1.7b. As a result, its current liabilities are equal to approximately 20% of its total assets. Low current liabilities are not boosting the ROCE too much.

Our Take On Linamar's ROCE

This is good to see, and with a sound ROCE, Linamar could be worth a closer look. Linamar looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

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.