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Today we'll evaluate Nelco Limited (NSE:NELCO) 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 of all, we'll work out how to calculate ROCE. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect 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. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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'.

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 Nelco:

0.34 = ₹214m ÷ (₹2.0b - ₹1.4b) (Based on the trailing twelve months to December 2018.)

So, Nelco has an ROCE of 34%.

View our latest analysis for Nelco

Does Nelco Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that Nelco's ROCE is meaningfully better than the 16% average in the Communications industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of the industry comparison, in absolute terms, Nelco's ROCE currently appears to be excellent.

Our data shows that Nelco currently has an ROCE of 34%, compared to its ROCE of 15% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly.

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. If Nelco 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 Nelco'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 counter this, investors can check if a company has high current liabilities relative to total assets.