Evaluating Koninklijke Philips N.V.’s (AMS:PHIA) Investments In Its Business

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Today we’ll look at Koninklijke Philips N.V. (AMS:PHIA) and reflect on its potential as an investment. 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.

Return On Capital Employed (ROCE): What is it?

ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the 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 Koninklijke Philips:

0.11 = €1.9b ÷ (€26b – €7.9b) (Based on the trailing twelve months to March 2019.)

Therefore, Koninklijke Philips has an ROCE of 11%.

Check out our latest analysis for Koninklijke Philips

Is Koninklijke Philips’s ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. We can see Koninklijke Philips’s ROCE is around the 12% average reported by the Medical Equipment industry. Independently of how Koninklijke Philips compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

As we can see, Koninklijke Philips currently has an ROCE of 11% compared to its ROCE 3 years ago, which was 6.3%. This makes us think the business might be improving.

ENXTAM:PHIA Past Revenue and Net Income, May 11th 2019
ENXTAM:PHIA Past Revenue and Net Income, May 11th 2019

Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Koninklijke Philips.

How Koninklijke Philips’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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Koninklijke Philips has total liabilities of €7.9b and total assets of €26b. As a result, its current liabilities are equal to approximately 31% of its total assets. With this level of current liabilities, Koninklijke Philips’s ROCE is boosted somewhat.

The Bottom Line On Koninklijke Philips’s ROCE

Koninklijke Philips’s ROCE does look good, but the level of current liabilities also contribute to that. Koninklijke Philips shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.

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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 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.