Today we'll evaluate Pacific Smiles Group Limited (ASX:PSQ) to determine whether it could have potential as an investment idea. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

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. Finally, we'll look at how its current liabilities affect its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. 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 Pacific Smiles Group:

0.19 = AU$13m ÷ (AU$84m - AU$18m) (Based on the trailing twelve months to June 2019.)

Therefore, Pacific Smiles Group has an ROCE of 19%.

Check out our latest analysis for Pacific Smiles Group

Does Pacific Smiles Group Have A Good ROCE?

One way to assess ROCE is to compare similar companies. Pacific Smiles Group's ROCE appears to be substantially greater than the 10.0% average in the Healthcare 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. Regardless of the industry comparison, in absolute terms, Pacific Smiles Group's ROCE currently appears to be excellent.

Pacific Smiles Group's current ROCE of 19% is lower than its ROCE in the past, which was 26%, 3 years ago. This makes us wonder if the business is facing new challenges. You can see in the image below how Pacific Smiles Group's ROCE compares to its industry. Click to see more on past growth.

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. 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 only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Pacific Smiles Group.

How Pacific Smiles Group's Current Liabilities Impact Its 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Pacific Smiles Group has total liabilities of AU$18m and total assets of AU$84m. As a result, its current liabilities are equal to approximately 21% of its total assets. The fairly low level of current liabilities won't have much impact on the already great ROCE.

Our Take On Pacific Smiles Group's ROCE

This is good to see, and with such a high ROCE, Pacific Smiles Group may be worth a closer look. Pacific Smiles Group shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.

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. Thank you for reading.