Today we'll evaluate Farmmi, Inc. (NASDAQ:FAMI) 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.
First of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
What is 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. 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 Farmmi:
0.16 = US$3.1m ÷ (US$22m - US$2.2m) (Based on the trailing twelve months to September 2018.)
So, Farmmi has an ROCE of 16%.
Is Farmmi's ROCE Good?
One way to assess ROCE is to compare similar companies. In our analysis, Farmmi's ROCE is meaningfully higher than the 8.8% average in the Food industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Regardless of where Farmmi sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
Farmmi's current ROCE of 16% is lower than its ROCE in the past, which was 59%, 3 years ago. Therefore we wonder if the company is facing new headwinds.
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. How cyclical is Farmmi? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
How Farmmi's Current Liabilities Impact Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.
Farmmi has total assets of US$22m and current liabilities of US$2.2m. As a result, its current liabilities are equal to approximately 10% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
The Bottom Line On Farmmi's ROCE
Overall, Farmmi has a decent ROCE and could be worthy of further research. Farmmi 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.