Today we are going to look at Gullewa Limited (ASX:GUL) to see whether it might be an attractive investment prospect. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
First up, we'll look at what ROCE is and how we calculate it. 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.
What is Return On Capital Employed (ROCE)?
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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?
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 Gullewa:
0.19 = AU$1.5m ÷ (AU$7.8m - AU$87k) (Based on the trailing twelve months to December 2018.)
Therefore, Gullewa has an ROCE of 19%.
Does Gullewa Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that Gullewa's ROCE is meaningfully better than the 9.5% average in the Metals and Mining industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Regardless of where Gullewa sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
Gullewa reported an ROCE of 19% -- better than 3 years ago, when the company didn't make a profit. That suggests the business has returned to profitability. You can see in the image below how Gullewa's ROCE compares to its industry. Click to see more on past growth.
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. We note Gullewa could be considered a cyclical business. How cyclical is Gullewa? 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 Gullewa's ROCE?
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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.
Gullewa has total assets of AU$7.8m and current liabilities of AU$87k. Therefore its current liabilities are equivalent to approximately 1.1% of its total assets. Low current liabilities have only a minimal impact on Gullewa's ROCE, making its decent returns more credible.
The Bottom Line On Gullewa's ROCE
This is good to see, and while better prospects may exist, Gullewa seems worth researching further. Gullewa 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.
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.