Why You Should Like Leon's Furniture Limited’s (TSE:LNF) ROCE

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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. Next, we'll compare it to others in its industry. And finally, we'll look at how its current liabilities are impacting its ROCE.

Understanding 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. 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?

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 Leon's Furniture:

0.14 = CA$152m ÷ (CA$1.7b - CA$608m) (Based on the trailing twelve months to December 2018.)

Therefore, Leon's Furniture has an ROCE of 14%.

Check out our latest analysis for Leon's Furniture

Is Leon's Furniture's ROCE Good?

One way to assess ROCE is to compare similar companies. In our analysis, Leon's Furniture's ROCE is meaningfully higher than the 9.9% average in the Specialty Retail industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of where Leon's Furniture sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

In our analysis, Leon's Furniture's ROCE appears to be 14%, compared to 3 years ago, when its ROCE 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, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our freereport on analyst forecasts for the company.

Do Leon's Furniture's Current Liabilities Skew Its ROCE?

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Leon's Furniture has total liabilities of CA$608m and total assets of CA$1.7b. As a result, its current liabilities are equal to approximately 35% of its total assets. With this level of current liabilities, Leon's Furniture's ROCE is boosted somewhat.

What We Can Learn From Leon's Furniture's ROCE

With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. Leon's Furniture shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this freecollection of companies delivering excellent earnings growth.

If you are like me, then you will not want to miss this freelist of growing companies that insiders are buying.

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 editorial-team@simplywallst.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.