Today we’ll evaluate Leon’s Furniture Limited (TSE:LNF) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into 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.
Return On Capital Employed (ROCE): What is it?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. 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?
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 Leon’s Furniture:
0.11 = CA$153m ÷ (CA$2.0b – CA$598m) (Based on the trailing twelve months to March 2019.)
Therefore, Leon’s Furniture has an ROCE of 11%.
Is Leon’s Furniture’s ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. It appears that Leon’s Furniture’s ROCE is fairly close to the Specialty Retail industry average of 10%. Independently of how Leon’s Furniture compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
It is important to remember that ROCE shows past performance, and is 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Since the future is so important for investors, you should check out our free report on analyst forecasts for Leon’s Furniture.
Leon’s Furniture’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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Leon’s Furniture has total assets of CA$2.0b and current liabilities of CA$598m. Therefore its current liabilities are equivalent to approximately 29% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
What We Can Learn From Leon’s Furniture’s ROCE
With that in mind, Leon’s Furniture’s ROCE appears pretty good. Leon’s Furniture 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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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.