Today we’ll look at The Eastern Company (NASDAQ:EML) 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.
Firstly, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. 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. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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?
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 Eastern:
0.11 = US$18m ÷ (US$191m – US$29m) (Based on the trailing twelve months to March 2019.)
So, Eastern has an ROCE of 11%.
Is Eastern’s ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. We can see Eastern’s ROCE is around the 11% average reported by the Machinery industry. Regardless of where Eastern sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
We can see that , Eastern currently has an ROCE of 11% compared to its ROCE 3 years ago, which was 7.1%. This makes us wonder if the company is improving.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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 only a point-in-time measure. How cyclical is Eastern? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Do Eastern’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.
Eastern has total liabilities of US$29m and total assets of US$191m. Therefore its current liabilities are equivalent to approximately 15% of its total assets. Low current liabilities are not boosting the ROCE too much.
The Bottom Line On Eastern’s ROCE
This is good to see, and with a sound ROCE, Eastern could be worth a closer look. There might be better investments than Eastern out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
I will like Eastern better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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