Today we are going to look at Greaves Cotton Limited (NSE:GREAVESCOT) to see whether it might be an attractive investment prospect. 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. 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. All else being equal, a better business will have a higher ROCE. 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 Greaves Cotton:

0.21 = ₹2.2b ÷ (₹15b - ₹4.3b) (Based on the trailing twelve months to June 2019.)

So, Greaves Cotton has an ROCE of 21%.

Check out our latest analysis for Greaves Cotton

Is Greaves Cotton's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Greaves Cotton's ROCE is meaningfully higher than the 13% average in the Machinery industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Separate from Greaves Cotton's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

You can see in the image below how Greaves Cotton's ROCE compares to its industry. Click to see more on past growth.

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. Since the future is so important for investors, you should check out our free report on analyst forecasts for Greaves Cotton.

How Greaves Cotton's Current Liabilities Impact Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.

Greaves Cotton has total liabilities of ₹4.3b and total assets of ₹15b. As a result, its current liabilities are equal to approximately 29% of its total assets. Low current liabilities are not boosting the ROCE too much.

What We Can Learn From Greaves Cotton's ROCE

With that in mind, Greaves Cotton's ROCE appears pretty good. There might be better investments than Greaves Cotton out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.

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.