Today we'll look at Communications Systems, Inc. (NASDAQ:JCS) 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. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. 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'.
How Do You Calculate Return On Capital Employed?
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 Communications Systems:
0.035 = US$1.6m ÷ (US$58m - US$11m) (Based on the trailing twelve months to September 2019.)
So, Communications Systems has an ROCE of 3.5%.
Does Communications Systems Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. We can see Communications Systems's ROCE is meaningfully below the Communications industry average of 7.0%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Independently of how Communications Systems compares to its industry, its ROCE in absolute terms is low; especially compared to the ~1.7% available in government bonds. It is likely that there are more attractive prospects out there.
Communications Systems reported an ROCE of 3.5% -- better than 3 years ago, when the company didn't make a profit. That implies the business has been improving. The image below shows how Communications Systems's ROCE compares to its industry, and you can click it to see more detail on its past growth.
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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Communications Systems.
What Are Current Liabilities, And How Do They Affect Communications Systems's ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Communications Systems has total assets of US$58m and current liabilities of US$11m. As a result, its current liabilities are equal to approximately 19% of its total assets. This is a modest level of current liabilities, which will have a limited impact on the ROCE.
What We Can Learn From Communications Systems's ROCE
Communications Systems 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).
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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