Today we’ll evaluate Southern Cross Electrical Engineering Limited (ASX:SXE) 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.

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.

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

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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?

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 Southern Cross Electrical Engineering:

0.074 = AU$11m ÷ (AU$230m – AU$77m) (Based on the trailing twelve months to June 2018.)

So, Southern Cross Electrical Engineering has an ROCE of 7.4%.

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Is Southern Cross Electrical Engineering’s ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. In this analysis, Southern Cross Electrical Engineering’s ROCE appears meaningfully below the 23% average reported by the Construction industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Separate from how Southern Cross Electrical Engineering 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.

As we can see, Southern Cross Electrical Engineering currently has an ROCE of 7.4% compared to its ROCE 3 years ago, which was 2.8%. This makes us wonder if the company is improving.

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. You can check if Southern Cross Electrical Engineering has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.

Southern Cross Electrical Engineering’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.

Southern Cross Electrical Engineering has total assets of AU$230m and current liabilities of AU$77m. As a result, its current liabilities are equal to approximately 34% of its total assets. Southern Cross Electrical Engineering has a medium level of current liabilities, which would boost its ROCE somewhat.

Our Take On Southern Cross Electrical Engineering’s ROCE

Unfortunately, its ROCE is still uninspiring, and there are potentially more attractive prospects out there. 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.

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

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.