Today we’ll evaluate Intelligent Systems Corporation (NYSEMKT:INS) 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.
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. Then we’ll determine how its current liabilities are affecting its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. 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’.
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 Intelligent Systems:
0.14 = -US$1.4m ÷ (US$27m – US$3.3m) (Based on the trailing twelve months to September 2018.)
So, Intelligent Systems has an ROCE of 14%.
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Does Intelligent Systems Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. Intelligent Systems’s ROCE appears to be substantially greater than the 9.5% average in the Software industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Regardless of where Intelligent Systems sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
Intelligent Systems delivered an ROCE of 14%, which is better than 3 years ago, as was making losses back then. This makes us wonder if the company is improving.
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 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. You can check if Intelligent Systems has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect Intelligent Systems’s 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Intelligent Systems has total liabilities of US$3.3m and total assets of US$27m. As a result, its current liabilities are equal to approximately 12% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
The Bottom Line On Intelligent Systems’s ROCE
This is good to see, and with a sound ROCE, Intelligent Systems could be worth a closer look. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
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 editorial-team@simplywallst.com.