Today we'll evaluate Bharat Gears Limited (NSE:BHARATGEAR) 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 of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.

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

ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the 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'.

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 Bharat Gears:

0.13 = ₹241m ÷ (₹4.2b - ₹2.3b) (Based on the trailing twelve months to June 2019.)

Therefore, Bharat Gears has an ROCE of 13%.

Check out our latest analysis for Bharat Gears

Is Bharat Gears's ROCE Good?

One way to assess ROCE is to compare similar companies. We can see Bharat Gears's ROCE is around the 15% average reported by the Auto Components industry. Separate from how Bharat Gears stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.

We can see that, Bharat Gears currently has an ROCE of 13% compared to its ROCE 3 years ago, which was 8.2%. This makes us think the business might be improving. The image below shows how Bharat Gears's ROCE compares to its industry, and you can click it to see more detail on its past growth.

When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is Bharat Gears? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

How Bharat Gears's Current Liabilities Impact Its ROCE

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Bharat Gears has total assets of ₹4.2b and current liabilities of ₹2.3b. As a result, its current liabilities are equal to approximately 54% of its total assets. Bharat Gears has a fairly high level of current liabilities, meaningfully impacting its ROCE.

The Bottom Line On Bharat Gears's ROCE

Despite this, the company also has a uninspiring ROCE, which is not an ideal combination in this analysis. Of course, you might also be able to find a better stock than Bharat Gears. So you may wish to see this free collection of other companies that have grown earnings strongly.

I will like Bharat Gears better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

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.

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. Thank you for reading.