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Today we are going to look at Gear4music (Holdings) plc (LON:G4M) 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.
Firstly, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. 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?
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 Gear4music (Holdings):
0.068 = UK£2.0m ÷ (UK£45m – UK£21m) (Based on the trailing twelve months to August 2018.)
So, Gear4music (Holdings) has an ROCE of 6.8%.
Does Gear4music (Holdings) Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, Gear4music (Holdings)’s ROCE appears to be significantly below the 13% average in the Specialty Retail industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Setting aside the industry comparison for now, Gear4music (Holdings)’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately 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. ROCE is only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Gear4music (Holdings).
What Are Current Liabilities, And How Do They Affect Gear4music (Holdings)’s 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.
Gear4music (Holdings) has total assets of UK£45m and current liabilities of UK£21m. Therefore its current liabilities are equivalent to approximately 47% of its total assets. Gear4music (Holdings) has a medium level of current liabilities, which would boost its ROCE somewhat.
The Bottom Line On Gear4music (Holdings)’s ROCE
With this level of liabilities and a mediocre ROCE, there are potentially better investments out there. But note: Gear4music (Holdings) may not be the best stock to buy. 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 are like me, then you will not want to miss this free list of growing companies that insiders are buying.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.