Why Hexagon Composites ASA’s (OB:HEX) Return On Capital Employed Might Be A Concern

Today we are going to look at Hexagon Composites ASA (OB:HEX) to see whether it might be an attractive investment prospect. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

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 is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the 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?

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 Hexagon Composites:

0.022 = øre48m ÷ (øre2.6b - øre440m) (Based on the trailing twelve months to December 2018.)

Therefore, Hexagon Composites has an ROCE of 2.2%.

Check out our latest analysis for Hexagon Composites

Is Hexagon Composites's ROCE Good?

One way to assess ROCE is to compare similar companies. In this analysis, Hexagon Composites's ROCE appears meaningfully below the 11% 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. Independently of how Hexagon Composites compares to its industry, its ROCE in absolute terms is low; especially compared to the ~1.8% available in government bonds. Readers may wish to look for more rewarding investments.

As we can see, Hexagon Composites currently has an ROCE of 2.2%, less than the 5.0% it reported 3 years ago. This makes us wonder if the business is facing new challenges.

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 freereport on analyst forecasts for Hexagon Composites.

What Are Current Liabilities, And How Do They Affect Hexagon Composites's ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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.

Hexagon Composites has total liabilities of øre440m and total assets of øre2.6b. Therefore its current liabilities are equivalent to approximately 17% of its total assets. This is not a high level of current liabilities, which would not boost the ROCE by much.

Our Take On Hexagon Composites's ROCE

Hexagon Composites has a poor ROCE, and there may be better investment prospects out there. But note: Hexagon Composites 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).

If you like to buy stocks alongside management, then you might just love this freelist 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.