Gear4music (Holdings) plc (LON:G4M) Might Not Be A Great Investment

Today we'll look at Gear4music (Holdings) plc (LON:G4M) 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 up, we'll look at what ROCE is and how we calculate it. 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 amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. 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?

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 Gear4music (Holdings):

0.068 = UK£1.6m ÷ (UK£45m - UK£21m) (Based on the trailing twelve months to August 2018.)

So, Gear4music (Holdings) has an ROCE of 6.8%.

See our latest analysis for Gear4music (Holdings)

Does Gear4music (Holdings) Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, Gear4music (Holdings)'s ROCE appears to be significantly below the 16% average in the Specialty Retail industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how Gear4music (Holdings) stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. Future performance is what matters, and you can see analyst predictions in our freereport on analyst forecasts for the company.

How Gear4music (Holdings)'s Current Liabilities Impact 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. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Gear4music (Holdings) has total liabilities of UK£21m and total assets of UK£45m. Therefore its current liabilities are equivalent to approximately 47% of its total assets. Gear4music (Holdings)'s middling level of current liabilities have the effect of boosting its ROCE a bit.

The Bottom Line On Gear4music (Holdings)'s ROCE

Unfortunately, its ROCE is still uninspiring, and there are potentially more attractive prospects out there. But note: Gear4music (Holdings) may not be the best stock to buy. So take a peek at this freelist of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

I will like Gear4music (Holdings) 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.