Spirent Communications plc (LON:SPT) Earns A Nice Return On Capital Employed

May 25, 2020

Today we'll evaluate Spirent Communications plc (LON:SPT) to determine whether it could have potential as an investment idea. 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.

First, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.

What is 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. In brief, it is a useful tool, but it is not without drawbacks. 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?

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 Spirent Communications:

0.20 = US$88m ÷ (US$605m - US$154m) (Based on the trailing twelve months to December 2019.)

Therefore, Spirent Communications has an ROCE of 20%.

Check out our latest analysis for Spirent Communications

Is Spirent Communications's ROCE Good?

One way to assess ROCE is to compare similar companies. Spirent Communications's ROCE appears to be substantially greater than the 6.8% average in the Communications industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of the industry comparison, in absolute terms, Spirent Communications's ROCE currently appears to be excellent.

Our data shows that Spirent Communications currently has an ROCE of 20%, compared to its ROCE of 8.5% 3 years ago. This makes us wonder if the company is improving. You can see in the image below how Spirent Communications's ROCE compares to its industry. Click to see more on past growth.

LSE:SPT Past Revenue and Net Income May 26th 2020

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during 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 Spirent Communications.

Do Spirent Communications'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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Spirent Communications has current liabilities of US$154m and total assets of US$605m. Therefore its current liabilities are equivalent to approximately 26% of its total assets. This is quite a low level of current liabilities which would not greatly boost the already high ROCE.

What We Can Learn From Spirent Communications's ROCE

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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.