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Are Federal Signal Corporation’s (NYSE:FSS) High Returns Really That Great?

Simply Wall St

Today we are going to look at Federal Signal Corporation (NYSE:FSS) to see whether it might be an attractive investment prospect. 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 of all, we'll work out how to calculate ROCE. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. In brief, it is a useful tool, but it is not without drawbacks. 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 Federal Signal:

0.14 = US$129m ÷ (US$1.1b - US$164m) (Based on the trailing twelve months to March 2019.)

So, Federal Signal has an ROCE of 14%.

See our latest analysis for Federal Signal

Does Federal Signal Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Federal Signal's ROCE is meaningfully better than the 11% average in the Machinery industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Regardless of where Federal Signal sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

Federal Signal's current ROCE of 14% is lower than 3 years ago, when the company reported a 20% ROCE. So investors might consider if it has had issues recently. You can click on the image below to see (in greater detail) how Federal Signal's past growth compares to other companies.

NYSE:FSS Past Revenue and Net Income, July 27th 2019

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. 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 free report on analyst forecasts for Federal Signal.

Federal Signal's Current Liabilities And Their Impact On Its ROCE

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Federal Signal has total assets of US$1.1b and current liabilities of US$164m. 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 Federal Signal's ROCE

Overall, Federal Signal has a decent ROCE and could be worthy of further research. Federal Signal 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.

If you are like me, then you will not want to miss this free list 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.