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Why Castleton Technology plc’s (LON:CTP) Use Of Investor Capital Doesn’t Look Great

Simply Wall St

Today we are going to look at Castleton Technology plc (LON:CTP) to see whether it might be an attractive investment prospect. 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. Second, we'll look at its ROCE compared 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 amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that 'one dollar invested in the company generates value of more than one dollar'.

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 Castleton Technology:

0.044 = UK£1.5m ÷ (UK£47m - UK£13m) (Based on the trailing twelve months to September 2019.)

So, Castleton Technology has an ROCE of 4.4%.

See our latest analysis for Castleton Technology

Is Castleton Technology's ROCE Good?

One way to assess ROCE is to compare similar companies. Using our data, Castleton Technology's ROCE appears to be significantly below the 12% average in the IT industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Setting aside the industry comparison for now, Castleton Technology's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.

In our analysis, Castleton Technology's ROCE appears to be 4.4%, compared to 3 years ago, when its ROCE was 2.7%. This makes us think about whether the company has been reinvesting shrewdly. You can see in the image below how Castleton Technology's ROCE compares to its industry. Click to see more on past growth.

AIM:CTP Past Revenue and Net Income, January 12th 2020

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. Since the future is so important for investors, you should check out our free report on analyst forecasts for Castleton Technology.

Do Castleton Technology'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.

Castleton Technology has total liabilities of UK£13m and total assets of UK£47m. As a result, its current liabilities are equal to approximately 28% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

What We Can Learn From Castleton Technology's ROCE

If Castleton Technology continues to earn an uninspiring ROCE, there may be better places to invest. Of course, you might also be able to find a better stock than Castleton Technology. So you may wish to see this free collection of other companies that have grown earnings strongly.

There are plenty of other companies that have insiders buying up shares. You probably do 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 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.

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. Thank you for reading.