Why You Should Care About TORM plc’s (CPH:TRMD A) Low Return On Capital

Today we’ll evaluate TORM plc (CPH:TRMD A) to determine whether it could have potential as an investment idea. 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, we’ll go over how we calculate ROCE. 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. All else being equal, a better business will have a higher ROCE. 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 TORM:

0.029 = US$45m ÷ (US$1.7b – US$174m) (Based on the trailing twelve months to June 2019.)

Therefore, TORM has an ROCE of 2.9%.

See our latest analysis for TORM

Is TORM’s ROCE Good?

One way to assess ROCE is to compare similar companies. In this analysis, TORM’s ROCE appears meaningfully below the 10% average reported by the Oil and Gas industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Putting aside TORM’s performance relative to its industry, its ROCE in absolute terms is poor – considering the risk of owning stocks compared to government bonds. It is likely that there are more attractive prospects out there.

TORM’s current ROCE of 2.9% is lower than 3 years ago, when the company reported a 10% ROCE. So investors might consider if it has had issues recently.

CPSE:TRMD A Past Revenue and Net Income, August 19th 2019
CPSE:TRMD A Past Revenue and Net Income, August 19th 2019

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. Remember that most companies like TORM are cyclical businesses. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

TORM’s Current Liabilities And Their Impact On Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 counter this, investors can check if a company has high current liabilities relative to total assets.

TORM has total liabilities of US$174m and total assets of US$1.7b. As a result, its current liabilities are equal to approximately 10% 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 TORM’s ROCE

While that is good to see, TORM has a low ROCE and does not look attractive in this analysis. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

I will like TORM better if I see some big insider buys. While we wait, check out this free list 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.