Today we’ll evaluate Mitchell Services Limited (ASX:MSV) to determine whether it could have potential as an investment idea. 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 up, we’ll look at what ROCE is and how we calculate it. 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 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. 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 Mitchell Services:
0.18 = AU$6.8m ÷ (AU$58m – AU$21m) (Based on the trailing twelve months to December 2018.)
Therefore, Mitchell Services has an ROCE of 18%.
Does Mitchell Services Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. Mitchell Services’s ROCE appears to be substantially greater than the 9.1% average in the Metals and Mining 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. Separate from Mitchell Services’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
Mitchell Services delivered an ROCE of 18%, which is better than 3 years ago, as was making losses back then. 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. ROCE is, after all, simply a snap shot of a single year. Given the industry it operates in, Mitchell Services could be considered cyclical. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
How Mitchell Services’s Current Liabilities Impact Its ROCE
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Mitchell Services has total assets of AU$58m and current liabilities of AU$21m. As a result, its current liabilities are equal to approximately 36% of its total assets. With this level of current liabilities, Mitchell Services’s ROCE is boosted somewhat.
Our Take On Mitchell Services’s ROCE
While its ROCE looks good, it’s worth remembering that the current liabilities are making the business look better. There might be better investments than Mitchell Services 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.
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