Today we are going to look at Energy Action Limited (ASX:EAX) to see whether it might be an attractive investment prospect. 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, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE 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 measures the ‘return’ (pre-tax profit) a company generates from capital employed in its business. Generally speaking a higher ROCE is better. 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?
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 Action:
0.20 = AU$4.2m ÷ (AU$23m – AU$2.9m) (Based on the trailing twelve months to June 2018.)
So, Energy Action has an ROCE of 20%.
Does Energy Action Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. We can see Energy Action’s ROCE is around the 20% average reported by the Professional Services industry. Regardless of where Energy Action sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
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. ROCE is only a point-in-time measure. If Energy Action is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
Energy Action’s Current Liabilities And Their Impact On 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 the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counteract this, we check if a company has high current liabilities, relative to its total assets.
Energy Action has total liabilities of AU$2.9m and total assets of AU$23m. Therefore its current liabilities are equivalent to approximately 12% of its total assets. Low current liabilities are not boosting the ROCE too much.
Our Take On Energy Action’s ROCE
This is good to see, and with a sound ROCE, Energy Action could be worth a closer look. Of course you might be able to find a better stock than Energy Action. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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