Today we’ll evaluate Tata Elxsi Limited (NSE:TATAELXSI) to determine whether it could have potential as an investment idea. Specifically, we’ll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.
Firstly, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE to similar companies. Then we’ll determine how its current liabilities are affecting 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. 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?
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 Tata Elxsi:
0.46 = ₹3.2b ÷ (₹10b – ₹2.0b) (Based on the trailing twelve months to September 2018.)
Therefore, Tata Elxsi has an ROCE of 46%.
Does Tata Elxsi Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. Tata Elxsi’s ROCE appears to be substantially greater than the 10% average in the Software industry. I think that’s good to see, since it implies the company is better than other companies at making the most of its capital. Setting aside the comparison to its industry for a moment, Tata Elxsi’s ROCE in absolute terms currently looks quite high.
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. ROCE is, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do Tata Elxsi’s Current Liabilities Skew 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. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counteract this, we check if a company has high current liabilities, relative to its total assets.
Tata Elxsi has total liabilities of ₹2.0b and total assets of ₹10b. As a result, its current liabilities are equal to approximately 20% of its total assets. The fairly low level of current liabilities won’t have much impact on the already great ROCE.
The Bottom Line On Tata Elxsi’s ROCE
Low current liabilities and high ROCE is a good combination, making Tata Elxsi look quite interesting. But note: Tata Elxsi 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).
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The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.