Here’s why Eimco Elecon (India) Limited’s (NSE:EIMCOELECO) Returns On Capital Matters So Much

Today we’ll evaluate Eimco Elecon (India) Limited (NSE:EIMCOELECO) to determine whether it could have potential as an investment idea. In particular, we’ll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First up, we’ll look at what ROCE is and how we calculate it. Second, we’ll look at its ROCE compared to similar companies. Finally, we’ll look at how its current liabilities affect its ROCE.

Understanding 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. In general, businesses with a higher ROCE are usually better quality. 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 Eimco Elecon (India):

0.071 = ₹218m ÷ (₹3.5b – ₹426m) (Based on the trailing twelve months to December 2018.)

Therefore, Eimco Elecon (India) has an ROCE of 7.1%.

View our latest analysis for Eimco Elecon (India)

Is Eimco Elecon (India)’s ROCE Good?

One way to assess ROCE is to compare similar companies. In this analysis, Eimco Elecon (India)’s ROCE appears meaningfully below the 15% average reported by the Machinery industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Putting aside Eimco Elecon (India)’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.

Eimco Elecon (India)’s current ROCE of 7.1% is lower than 3 years ago, when the company reported a 12% ROCE. This makes us wonder if the business is facing new challenges.

NSEI:EIMCOELECO Past Revenue and Net Income, March 15th 2019
NSEI:EIMCOELECO Past Revenue and Net Income, March 15th 2019

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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

How Eimco Elecon (India)’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 counter this, investors can check if a company has high current liabilities relative to total assets.

Eimco Elecon (India) has total liabilities of ₹426m and total assets of ₹3.5b. Therefore its current liabilities are equivalent to approximately 12% of its total assets. This is a modest level of current liabilities, which will have a limited impact on the ROCE.

The Bottom Line On Eimco Elecon (India)’s ROCE

While that is good to see, Eimco Elecon (India) has a low ROCE and does not look attractive in this analysis. But note: Eimco Elecon (India) may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

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.