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Today we’ll evaluate Varroc Engineering Limited (NSE:VARROC) 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 of all, we’ll work out how to calculate ROCE. Next, we’ll compare it to others in its industry. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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 Varroc Engineering:
0.16 = ₹6.1b ÷ (₹88b – ₹49b) (Based on the trailing twelve months to March 2019.)
Therefore, Varroc Engineering has an ROCE of 16%.
Does Varroc Engineering Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. We can see Varroc Engineering’s ROCE is around the 16% average reported by the Auto Components industry. Separate from Varroc Engineering’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
In our analysis, Varroc Engineering’s ROCE appears to be 16%, compared to 3 years ago, when its ROCE was 11%. This makes us think the business might be improving.
When considering this metric, keep in mind that it is backwards looking, and 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 Varroc Engineering.
How Varroc Engineering’s Current Liabilities Impact 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.
Varroc Engineering has total liabilities of ₹49b and total assets of ₹88b. Therefore its current liabilities are equivalent to approximately 57% of its total assets. Varroc Engineering’s current liabilities are fairly high, which increases its ROCE significantly.
What We Can Learn From Varroc Engineering’s ROCE
While its ROCE looks decent, it wouldn’t look so good if it reduced current liabilities. There might be better investments than Varroc Engineering out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
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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 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.