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Today we are going to look at Hammond Power Solutions Inc. (TSE:HPS.A) to see whether it might be an attractive investment prospect. In particular, we’ll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
First up, we’ll look at what ROCE is and how we calculate it. Next, we’ll compare it to others in its industry. Finally, we’ll look at how its current liabilities affect 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. In general, businesses with a higher ROCE are usually better quality. 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.’
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 Hammond Power Solutions:
0.13 = CA$16m ÷ (CA$207m – CA$89m) (Based on the trailing twelve months to March 2019.)
Therefore, Hammond Power Solutions has an ROCE of 13%.
Is Hammond Power Solutions’s ROCE Good?
One way to assess ROCE is to compare similar companies. We can see Hammond Power Solutions’s ROCE is around the 11% average reported by the Electrical industry. Separate from Hammond Power Solutions’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
We can see that , Hammond Power Solutions currently has an ROCE of 13% compared to its ROCE 3 years ago, which was 10%. This makes us think about whether the company has been reinvesting shrewdly.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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. You can check if Hammond Power Solutions has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect Hammond Power Solutions’s 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Hammond Power Solutions has total assets of CA$207m and current liabilities of CA$89m. As a result, its current liabilities are equal to approximately 43% of its total assets. Hammond Power Solutions has a middling amount of current liabilities, increasing its ROCE somewhat.
Our Take On Hammond Power Solutions’s ROCE
Hammond Power Solutions’s ROCE does look good, but the level of current liabilities also contribute to that. Hammond Power Solutions looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.
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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 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. Thank you for reading.