Today we'll evaluate Airo Lam Limited (NSE:AIROLAM) to determine whether it could have potential as an investment idea. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.

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

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. All else being equal, a better business will have a higher ROCE. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'

How Do You Calculate Return On Capital Employed?

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 Airo Lam:

0.17 = ₹75m ÷ (₹902m - ₹470m) (Based on the trailing twelve months to March 2019.)

So, Airo Lam has an ROCE of 17%.

Check out our latest analysis for Airo Lam

Does Airo Lam Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Airo Lam's ROCE is meaningfully higher than the 14% average in the Forestry 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. Separate from Airo Lam's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

The image below shows how Airo Lam's ROCE compares to its industry, and you can click it to see more detail on its past growth.

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. If Airo Lam is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect Airo Lam's ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.