Shareholders Should Look Hard At Graham Corporation’s (NYSE:GHM) 4.0% Return On Capital

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Today we are going to look at Graham Corporation (NYSE:GHM) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed 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?

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 Graham:

0.04 = US$4.3m ÷ (US$157m - US$49m) (Based on the trailing twelve months to December 2018.)

Therefore, Graham has an ROCE of 4.0%.

View our latest analysis for Graham

Is Graham's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. In this analysis, Graham'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. Regardless of how Graham stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). It is likely that there are more attractive prospects out there.

Graham's current ROCE of 4.0% is lower than its ROCE in the past, which was 11%, 3 years ago. This makes us wonder if the business is facing new challenges.

It is important to remember that ROCE shows past performance, and is 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. ROCE is only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our freereport on analyst forecasts for the company.

How Graham'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. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Graham has total liabilities of US$49m and total assets of US$157m. As a result, its current liabilities are equal to approximately 31% of its total assets. In light of sufficient current liabilities to noticeably boost the ROCE, Graham's ROCE is concerning.

Our Take On Graham's ROCE

So researching other companies may be a better use of your time. But note: make sure you look for a great company, not just the first idea you come across. 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.