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Why You Should Care About Gear Energy Ltd.’s (TSE:GXE) Low Return On Capital

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Today we'll look at Gear Energy Ltd. (TSE:GXE) and reflect on its potential as an investment. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

What is 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. All else being equal, a better business will have a higher ROCE. 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.'

How Do You Calculate Return On Capital Employed?

The formula for calculating the return on capital employed is:

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Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

Or for Gear Energy:

0.014 = CA$5.1m ÷ (CA$386m - CA$22m) (Based on the trailing twelve months to March 2019.)

So, Gear Energy has an ROCE of 1.4%.

See our latest analysis for Gear Energy

Does Gear Energy Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, Gear Energy's ROCE appears to be significantly below the 5.4% average in the Oil and Gas industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Putting aside Gear Energy's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. There are potentially more appealing investments elsewhere.

Gear Energy delivered an ROCE of 1.4%, which is better than 3 years ago, as was making losses back then. This makes us wonder if the company is improving.

TSX:GXE Past Revenue and Net Income, June 4th 2019
TSX:GXE Past Revenue and Net Income, June 4th 2019

When considering this metric, keep in mind that it is backwards looking, and 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. Given the industry it operates in, Gear Energy could be considered cyclical. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Do Gear Energy's Current Liabilities Skew 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Gear Energy has total liabilities of CA$22m and total assets of CA$386m. Therefore its current liabilities are equivalent to approximately 5.7% of its total assets. With barely any current liabilities, there is minimal impact on Gear Energy's admittedly low ROCE.

Our Take On Gear Energy's ROCE

Nevertheless, there are potentially more attractive companies to invest in. Of course, you might also be able to find a better stock than Gear Energy. So you may wish to see this free collection of other companies that have grown earnings strongly.

If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

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.