A Critical analysis of HAL's financial performance and on its potential as an investment

Today we’ll look at Hindustan Aeronautics Limited (NSE:HAL) 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, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. Finally, we’ll look at how its current liabilities affect its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. 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.’

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 Hindustan Aeronautics:

0.069 = ₹16b ÷ (₹492b – ₹254b) (Based on the trailing twelve months to March 2018.)

So, Hindustan Aeronautics has an ROCE of 6.9%.

Does Hindustan Aeronautics Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. We can see Hindustan Aeronautics’s ROCE is meaningfully below the Aerospace & Defense industry average of 12%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Independently of how Hindustan Aeronautics compares to its industry, its ROCE in absolute terms is low; especially compared to the ~7.6% available in government bonds. There are potentially more appealing investments elsewhere.

Hindustan Aeronautics reported an ROCE of 6.9% — better than 3 years ago, when the company didn’t make a profit. That implies the business has been improving.

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. How cyclical is Hindustan Aeronautics? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

Do Hindustan Aeronautics’s Current Liabilities Skew Its ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Hindustan Aeronautics has total liabilities of ₹254b and total assets of ₹492b. As a result, its current liabilities are equal to approximately 52% of its total assets. Current liabilities of this level result in a meaningful boost to Hindustan Aeronautics’s ROCE.

The Bottom Line On Hindustan Aeronautics’s ROCE

Hindustan Aeronautics’s ROCE is also pretty low (in absolute terms), making the stock look unattractive on this analysis. Of course, you might also be able to find a better stock than Hindustan Aeronautics. So you may wish to see this free collection of other companies that have grown earnings strongly.