Why You Should Care About The L.S. Starrett Company’s (NYSE:SCX) Low Return On Capital

Today we'll look at The L.S. Starrett Company (NYSE:SCX) and reflect on its potential as an investment. 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.

Firstly, 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. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. 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?

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 L.S. Starrett:

0.051 = US$7.9m ÷ (US$181m - US$26m) (Based on the trailing twelve months to December 2018.)

So, L.S. Starrett has an ROCE of 5.1%.

See our latest analysis for L.S. Starrett

Does L.S. Starrett Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, L.S. Starrett's ROCE appears to be significantly below the 11% average in the Machinery industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Regardless of how L.S. Starrett stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). Readers may wish to look for more rewarding investments.

As we can see, L.S. Starrett currently has an ROCE of 5.1% compared to its ROCE 3 years ago, which was 2.9%. This makes us wonder if the company is improving.

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 only a point-in-time measure. If L.S. Starrett is cyclical, it could make sense to check out this freegraph of past earnings, revenue and cash flow.

How L.S. Starrett's Current Liabilities Impact Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

L.S. Starrett has total liabilities of US$26m and total assets of US$181m. As a result, its current liabilities are equal to approximately 14% of its total assets. With a very reasonable level of current liabilities, so the impact on ROCE is fairly minimal.

Our Take On L.S. Starrett's ROCE

That's not a bad thing, however L.S. Starrett has a weak ROCE and may not be an attractive investment. You might be able to find a better investment than L.S. Starrett. If you want a selection of possible winners, check out this freelist of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

If you are like me, then you will not want to miss this freelist of growing companies that insiders are buying.

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.