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Today we'll evaluate Elecon Engineering Company Limited (NSE:ELECON) 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.

Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE 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. In general, businesses with a higher ROCE are usually better quality. 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.'

So, How Do We Calculate ROCE?

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 Elecon Engineering:

0.11 = ₹1.2b ÷ (₹22b - ₹11b) (Based on the trailing twelve months to December 2018.)

Therefore, Elecon Engineering has an ROCE of 11%.

Check out our latest analysis for Elecon Engineering

Does Elecon Engineering Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, Elecon Engineering's ROCE appears to be significantly below the 15% average in the Electrical industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Setting aside the industry comparison for now, Elecon Engineering's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.

It is important to remember that ROCE shows past performance, and is 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 Elecon Engineering is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.

Do Elecon Engineering's Current Liabilities Skew 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 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.

Elecon Engineering has total liabilities of ₹11b and total assets of ₹22b. Therefore its current liabilities are equivalent to approximately 51% of its total assets. Elecon Engineering has a fairly high level of current liabilities, meaningfully impacting its ROCE.

Our Take On Elecon Engineering's ROCE

Even so, the company reports a mediocre ROCE, and there may be better investments out there. You might be able to find a better buy than Elecon Engineering. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

If you are like me, then you will not want to miss this free list of growing companies that insiders are 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.