Today we'll look at Ador Welding Limited (NSE:ADORWELD) and reflect on its potential as an investment. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
Return On Capital Employed (ROCE): What is it?
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. In brief, it is a useful tool, but it is not without drawbacks. 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?
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 Ador Welding:
0.11 = ₹285m ÷ (₹4.3b - ₹1.7b) (Based on the trailing twelve months to March 2018.)
So, Ador Welding has an ROCE of 11%.
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Is Ador Welding's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Ador Welding's ROCE appears meaningfully below the 15% average reported by the Machinery industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how Ador Welding stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.
In our analysis, Ador Welding's ROCE appears to be 11%, compared to 3 years ago, when its ROCE was 7.9%. This makes us wonder if the company is improving.
When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. You can check if Ador Welding has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Do Ador Welding'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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Ador Welding has total liabilities of ₹1.7b and total assets of ₹4.3b. As a result, its current liabilities are equal to approximately 40% of its total assets. Ador Welding has a medium level of current liabilities, which would boost its ROCE somewhat.
What We Can Learn From Ador Welding's ROCE
With this level of liabilities and a mediocre ROCE, there are potentially better investments out there. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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 firstname.lastname@example.org. 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.