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Why Richelieu Hardware Ltd.’s (TSE:RCH) Return On Capital Employed Is Impressive

Simply Wall St

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Today we'll look at Richelieu Hardware Ltd. (TSE:RCH) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

First, 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.

What is Return On Capital Employed (ROCE)?

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested 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'.

How Do You Calculate Return On Capital Employed?

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 Richelieu Hardware:

0.19 = CA$90m ÷ (CA$588m - CA$103m) (Based on the trailing twelve months to February 2019.)

So, Richelieu Hardware has an ROCE of 19%.

Check out our latest analysis for Richelieu Hardware

Is Richelieu Hardware's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. Richelieu Hardware's ROCE appears to be substantially greater than the 12% average in the Trade Distributors 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. Independently of how Richelieu Hardware compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

TSX:RCH Past Revenue and Net Income, June 14th 2019

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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Do Richelieu Hardware's Current Liabilities Skew Its 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Richelieu Hardware has total liabilities of CA$103m and total assets of CA$588m. As a result, its current liabilities are equal to approximately 18% of its total assets. Low current liabilities are not boosting the ROCE too much.

What We Can Learn From Richelieu Hardware's ROCE

This is good to see, and with a sound ROCE, Richelieu Hardware could be worth a closer look. Richelieu Hardware looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

I will like Richelieu Hardware better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider 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 editorial-team@simplywallst.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.