What Can We Make Of Psychemedics Corporation’s (NASDAQ:PMD) High Return On Capital?

Today we are going to look at Psychemedics Corporation (NASDAQ:PMD) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared 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 metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'

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 Psychemedics:

0.28 = US$5.9m ÷ (US$25m - US$4.2m) (Based on the trailing twelve months to June 2019.)

Therefore, Psychemedics has an ROCE of 28%.

View our latest analysis for Psychemedics

Does Psychemedics Have A Good ROCE?

One way to assess ROCE is to compare similar companies. Using our data, we find that Psychemedics's ROCE is meaningfully better than the 11% average in the Healthcare industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Putting aside its position relative to its industry for now, in absolute terms, Psychemedics's ROCE is currently very good.

In our analysis, Psychemedics's ROCE appears to be 28%, compared to 3 years ago, when its ROCE was 16%. This makes us think the business might be improving.

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is Psychemedics? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

Psychemedics's Current Liabilities And Their Impact On Its ROCE

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Psychemedics has total assets of US$25m and current liabilities of US$4.2m. As a result, its current liabilities are equal to approximately 17% of its total assets. This is quite a low level of current liabilities which would not greatly boost the already high ROCE.

Our Take On Psychemedics's ROCE

With low current liabilities and a high ROCE, Psychemedics could be worthy of further investigation. Psychemedics 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 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 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.