Today we’ll look at Illinois Tool Works Inc. (NYSE:ITW) and reflect on its potential as an investment. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. 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?
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 Illinois Tool Works:
0.27 = US$3.5b ÷ (US$15b – US$2.2b) (Based on the trailing twelve months to June 2019.)
So, Illinois Tool Works has an ROCE of 27%.
Is Illinois Tool Works’s ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. Illinois Tool Works’s ROCE appears to be substantially greater than the 12% average in the Machinery industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Putting aside its position relative to its industry for now, in absolute terms, Illinois Tool Works’s ROCE is currently very good.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Illinois Tool Works.
Do Illinois Tool Works’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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Illinois Tool Works has total liabilities of US$2.2b and total assets of US$15b. Therefore its current liabilities are equivalent to approximately 14% of its total assets. A minimal amount of current liabilities limits the impact on ROCE.
Our Take On Illinois Tool Works’s ROCE
This is good to see, and with such a high ROCE, Illinois Tool Works may be worth a closer look. Illinois Tool Works looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.
I will like Illinois Tool Works better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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