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Today we are going to look at Ambani Organics Limited (NSE:AMBANIORG) to see whether it might be an attractive investment prospect. 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, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed 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?
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 Ambani Organics:
0.24 = ₹49m ÷ (₹614m - ₹408m) (Based on the trailing twelve months to March 2019.)
Therefore, Ambani Organics has an ROCE of 24%.
See our latest analysis for Ambani Organics
Does Ambani Organics Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Ambani Organics's ROCE is meaningfully higher than the 17% average in the Chemicals 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 Ambani Organics's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
When considering this metric, keep in mind that it is backwards looking, and 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. You can check if Ambani Organics has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
How Ambani Organics's Current Liabilities Impact Its 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 counteract this, we check if a company has high current liabilities, relative to its total assets.