Today we’ll evaluate Scales Corporation Limited (NZSE:SCL) 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.
First, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. Finally, we’ll look at how its current liabilities affect 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. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. 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?
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 Scales:
0.12 = NZ$41m ÷ (NZ$411m – NZ$73m) (Based on the trailing twelve months to December 2018.)
So, Scales has an ROCE of 12%.
Does Scales Have A Good ROCE?
One way to assess ROCE is to compare similar companies. Scales’s ROCE appears to be substantially greater than the 8.5% average in the Food industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of where Scales sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
As we can see, Scales currently has an ROCE of 12%, less than the 23% it reported 3 years ago. 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. 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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do Scales’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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Scales has total assets of NZ$411m and current liabilities of NZ$73m. As a result, its current liabilities are equal to approximately 18% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
Our Take On Scales’s ROCE
With that in mind, Scales’s ROCE appears pretty good. Scales 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.
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