Today we'll evaluate Connexion Telematics Ltd (ASX:CXZ) to determine whether it could have potential as an investment idea. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
Firstly, 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.
Return On Capital Employed (ROCE): What is it?
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?
The formula for calculating the return on capital employed is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
Or for Connexion Telematics:
0.29 = AU$509k ÷ (AU$3.4m - AU$1.6m) (Based on the trailing twelve months to June 2019.)
Therefore, Connexion Telematics has an ROCE of 29%.
Does Connexion Telematics Have A Good ROCE?
One way to assess ROCE is to compare similar companies. In our analysis, Connexion Telematics's ROCE is meaningfully higher than the 17% average in the Software industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Putting aside its position relative to its industry for now, in absolute terms, Connexion Telematics's ROCE is currently very good.
You can click on the image below to see (in greater detail) how Connexion Telematics's past growth compares to other companies.
When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. How cyclical is Connexion Telematics? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
How Connexion Telematics's Current Liabilities Impact Its ROCE
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counter this, investors can check if a company has high current liabilities relative to total assets.
Connexion Telematics has total liabilities of AU$1.6m and total assets of AU$3.4m. Therefore its current liabilities are equivalent to approximately 48% of its total assets. Connexion Telematics has a medium level of current liabilities, boosting its ROCE somewhat.
What We Can Learn From Connexion Telematics's ROCE
Despite this, it reports a high ROCE, and may be worth investigating further. Connexion Telematics shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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 email@example.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.