Don’t Buy Toromont Industries Ltd. (TSE:TIH) Until You Understand Its ROCE

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Today we'll look at Toromont Industries Ltd. (TSE:TIH) and reflect on its potential as an investment. 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 of all, we'll work out how to 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 measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the 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?

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 Toromont Industries:

0.17 = CA$256m ÷ (CA$3.1b - CA$1.1b) (Based on the trailing twelve months to September 2018.)

So, Toromont Industries has an ROCE of 17%.

See our latest analysis for Toromont Industries

Does Toromont Industries Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. It appears that Toromont Industries's ROCE is fairly close to the Trade Distributors industry average of 17%. Independently of how Toromont Industries compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our freereport on analyst forecasts for the company.

Do Toromont Industries's Current Liabilities Skew Its ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Toromont Industries has total assets of CA$3.1b and current liabilities of CA$1.1b. Therefore its current liabilities are equivalent to approximately 35% of its total assets. With this level of current liabilities, Toromont Industries's ROCE is boosted somewhat.

Our Take On Toromont Industries's ROCE

While its ROCE looks good, it's worth remembering that the current liabilities are making the business look better. Of course you might be able to find a better stock than Toromont Industries. So you may wish to see this freecollection of other companies that have grown earnings strongly.

I will like Toromont Industries better if I see some big insider buys. While we wait, check out this freelist of growing companies with considerable, recent, insider buying.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.