Today we'll look at Grand Gulf Energy Limited (ASX:GGE) and reflect on its potential as an investment. 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 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 is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. All else being equal, a better business will have a higher ROCE. 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?
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 Grand Gulf Energy:
0.35 = AU$1.1m ÷ (AU$3.2m - AU$84k) (Based on the trailing twelve months to December 2019.)
So, Grand Gulf Energy has an ROCE of 35%.
Does Grand Gulf Energy Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Grand Gulf Energy's ROCE is meaningfully higher than the 7.4% average in the Oil and Gas industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of the industry comparison, in absolute terms, Grand Gulf Energy's ROCE currently appears to be excellent.
Grand Gulf Energy delivered an ROCE of 35%, which is better than 3 years ago, as was making losses back then. That implies the business has been improving. The image below shows how Grand Gulf Energy's ROCE compares to its industry, and you can click it to see more detail on its past growth.
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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. We note Grand Gulf Energy could be considered a cyclical business. How cyclical is Grand Gulf Energy? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect Grand Gulf Energy's ROCE?
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Grand Gulf Energy has current liabilities of AU$84k and total assets of AU$3.2m. As a result, its current liabilities are equal to approximately 2.6% of its total assets. Minimal current liabilities are not distorting Grand Gulf Energy's impressive ROCE.
Our Take On Grand Gulf Energy's ROCE
This should mark the company as worthy of further investigation. Grand Gulf Energy 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.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.