Here’s why Gelsenwasser AG’s (FRA:WWG) Returns On Capital Matters So Much

Today we'll evaluate Gelsenwasser AG (FRA:WWG) 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. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.

Return On Capital Employed (ROCE): What is it?

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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 Gelsenwasser:

0.03 = €41m ÷ (€1.6b - €260m) (Based on the trailing twelve months to June 2018.)

So, Gelsenwasser has an ROCE of 3.0%.

Check out our latest analysis for Gelsenwasser

Does Gelsenwasser Have A Good ROCE?

One way to assess ROCE is to compare similar companies. In this analysis, Gelsenwasser's ROCE appears meaningfully below the 5.7% average reported by the Integrated Utilities industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Regardless of how Gelsenwasser stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). Readers may wish to look for more rewarding investments.

Gelsenwasser's current ROCE of 3.0% is lower than its ROCE in the past, which was 5.1%, 3 years ago. This makes us wonder if the business is facing new challenges.

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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. If Gelsenwasser is cyclical, it could make sense to check out this freegraph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect Gelsenwasser'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. 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.

Gelsenwasser has total assets of €1.6b and current liabilities of €260m. As a result, its current liabilities are equal to approximately 16% of its total assets. With a very reasonable level of current liabilities, so the impact on ROCE is fairly minimal.

What We Can Learn From Gelsenwasser's ROCE

Gelsenwasser has a poor ROCE, and there may be better investment prospects out there. You might be able to find a better buy than Gelsenwasser. If you want a selection of possible winners, check out this freelist of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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