Should You Like Spirax-Sarco Engineering plc’s (LON:SPX) High Return On Capital Employed?

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Today we'll evaluate Spirax-Sarco Engineering plc (LON:SPX) to determine whether it could have potential as an investment idea. 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.

Firstly, 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 is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the 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 Spirax-Sarco Engineering:

0.18 = UK£217m ÷ (UK£1.5b - UK£223m) (Based on the trailing twelve months to June 2018.)

Therefore, Spirax-Sarco Engineering has an ROCE of 18%.

View our latest analysis for Spirax-Sarco Engineering

Is Spirax-Sarco Engineering's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Spirax-Sarco Engineering's ROCE is meaningfully higher than the 13% average in the Machinery industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Regardless of where Spirax-Sarco Engineering sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

Spirax-Sarco Engineering's current ROCE of 18% is lower than 3 years ago, when the company reported a 31% ROCE. This makes us wonder if the business is facing new challenges.

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. ROCE is, after all, simply a snap shot of a single year. Since the future is so important for investors, you should check out our freereport on analyst forecasts for Spirax-Sarco Engineering.

Do Spirax-Sarco Engineering'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 the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counter this, investors can check if a company has high current liabilities relative to total assets.

Spirax-Sarco Engineering has total liabilities of UK£223m and total assets of UK£1.5b. As a result, its current liabilities are equal to approximately 15% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.

Our Take On Spirax-Sarco Engineering's ROCE

This is good to see, and with a sound ROCE, Spirax-Sarco Engineering could be worth a closer look. Of course you might be able to find a better stock than Spirax-Sarco Engineering. So you may wish to see this freecollection of other companies that have grown earnings strongly.

I will like Spirax-Sarco Engineering better if I see some big insider buys. While we wait, check out this freelist of growing companies with considerable, recent, insider buying.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.