Today we’ll look at McPherson’s Limited (ASX:MCP) and reflect on its potential as an investment. Specifically, we’ll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.

Firstly, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE to similar companies. Last but not least, we’ll look at what impact its current liabilities have on 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. In general, businesses with a higher ROCE are usually better quality. 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’.

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 McPherson’s:

0.22 = AU$22m ÷ (AU$156m – AU$56m) (Based on the trailing twelve months to June 2018.)

Therefore, McPherson’s has an ROCE of 22%.

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Does McPherson’s Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. We can see McPherson’s’s ROCE is around the 26% average reported by the Consumer Durables industry. Putting aside its position relative to its industry for now, in absolute terms, McPherson’s’s ROCE is currently very good.

Our data shows that McPherson’s currently has an ROCE of 22%, compared to its ROCE of 8.9% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly.

When considering this metric, keep in mind that it is backwards looking, and 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for McPherson’s.

McPherson’s’s Current Liabilities And Their Impact On Its ROCE

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counter this, investors can check if a company has high current liabilities relative to total assets.

McPherson’s has total liabilities of AU$56m and total assets of AU$156m. Therefore its current liabilities are equivalent to approximately 36% of its total assets. McPherson’s’s ROCE is boosted somewhat by its middling amount of current liabilities.

What We Can Learn From McPherson’s’s ROCE

Despite this, it reports a high ROCE, and may be worth investigating further. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

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

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.