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Are Mitchell Services Limited’s (ASX:MSV) High Returns Really That Great?

Simply Wall St

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Today we'll look at Mitchell Services Limited (ASX:MSV) 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.

First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

Understanding Return On Capital Employed (ROCE)

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. 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 Mitchell Services:

0.18 = AU$6.8m ÷ (AU$58m - AU$21m) (Based on the trailing twelve months to December 2018.)

So, Mitchell Services has an ROCE of 18%.

View our latest analysis for Mitchell Services

Is Mitchell Services's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that Mitchell Services's ROCE is meaningfully better than the 9.5% average in the Metals and Mining industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how Mitchell Services compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

Mitchell Services has an ROCE of 18%, but it didn't have an ROCE 3 years ago, since it was unprofitable. This makes us wonder if the company is improving.

ASX:MSV Past Revenue and Net Income, June 16th 2019

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. We note Mitchell Services could be considered a cyclical business. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Mitchell Services.

Mitchell Services's Current Liabilities And Their Impact On Its ROCE

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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.

Mitchell Services has total liabilities of AU$21m and total assets of AU$58m. As a result, its current liabilities are equal to approximately 36% of its total assets. Mitchell Services has a medium level of current liabilities, which would boost the ROCE.

What We Can Learn From Mitchell Services's ROCE

With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. There might be better investments than Mitchell Services 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.

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

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.