Today we’ll evaluate Spectrum Electrical Industries Limited (NSE:SPECTRUM) to determine whether it could have potential as an investment idea. To be precise, we’ll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
First of all, we’ll work out how to calculate ROCE. Next, we’ll compare it to others in its industry. 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. Overall, it is a valuable metric that has its flaws. 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 Spectrum Electrical Industries:
0.23 = ₹123m ÷ (₹1.1b – ₹553m) (Based on the trailing twelve months to March 2018.)
So, Spectrum Electrical Industries has an ROCE of 23%.
View our latest analysis for Spectrum Electrical Industries
Is Spectrum Electrical Industries’s ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Spectrum Electrical Industries’s ROCE is meaningfully higher than the 16% average in the Electrical industry. I think that’s good to see, since it implies the company is better than other companies at making the most of its capital. Regardless of where Spectrum Electrical Industries sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
In our analysis, Spectrum Electrical Industries’s ROCE appears to be 23%, compared to 3 years ago, when its ROCE was 0.5%. This makes us wonder if the company is improving.
It is important to remember that ROCE shows past performance, and is 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. You can check if Spectrum Electrical Industries has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Do Spectrum Electrical Industries’s Current Liabilities Skew Its ROCE?
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that 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.