Today we’ll look at Energy One Limited (ASX:EOL) 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.
First of all, we’ll work out how to 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 is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. 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?
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 Energy One:
0.16 = AU$2.7m ÷ (AU$26m – AU$8.4m) (Based on the trailing twelve months to December 2019.)
Therefore, Energy One has an ROCE of 16%.
Does Energy One Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, Energy One’s ROCE appears to be around the 16% average of the Software industry. Regardless of where Energy One sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
You can click on the image below to see (in greater detail) how Energy One’s past growth compares to other companies.
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. How cyclical is Energy One? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
How Energy One’s Current Liabilities Impact 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.
Energy One has total assets of AU$26m and current liabilities of AU$8.4m. Therefore its current liabilities are equivalent to approximately 33% of its total assets. Energy One has a medium level of current liabilities, which would boost the ROCE.
The Bottom Line On Energy One’s ROCE
Energy One’s ROCE does look good, but the level of current liabilities also contribute to that. Energy One 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.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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.
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