Here's What Electrocomponents plc's (LON:ECM) ROCE Can Tell Us

Today we'll look at Electrocomponents plc (LON:ECM) and reflect on its potential as an investment. 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. 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. Generally speaking a higher ROCE is better. 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'.

How Do You Calculate Return On Capital Employed?

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 Electrocomponents:

0.22 = UK£203m ÷ (UK£1.4b - UK£488m) (Based on the trailing twelve months to March 2019.)

So, Electrocomponents has an ROCE of 22%.

See our latest analysis for Electrocomponents

Does Electrocomponents Have A Good ROCE?

One way to assess ROCE is to compare similar companies. Using our data, we find that Electrocomponents's ROCE is meaningfully better than the 13% average in the Electronic 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 the industry comparison, in absolute terms, Electrocomponents's ROCE currently appears to be excellent.

We can see that, Electrocomponents currently has an ROCE of 22% compared to its ROCE 3 years ago, which was 12%. This makes us wonder if the company is improving. The image below shows how Electrocomponents's ROCE compares to its industry.

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. ROCE is only a point-in-time measure. Since the future is so important for investors, you should check out our free report on analyst forecasts for Electrocomponents.

Do Electrocomponents's Current Liabilities Skew 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Electrocomponents has total assets of UK£1.4b and current liabilities of UK£488m. Therefore its current liabilities are equivalent to approximately 35% of its total assets. A medium level of current liabilities boosts Electrocomponents's ROCE somewhat.

What We Can Learn From Electrocomponents's ROCE

Still, it has a high ROCE, and may be an interesting prospect for further research. There might be better investments than Electrocomponents 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.