Today we'll evaluate Innospec Inc. (NASDAQ:IOSP) 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 up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. 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 Innospec:
0.14 = US$162m ÷ (US$1.5b - US$304m) (Based on the trailing twelve months to December 2019.)
So, Innospec has an ROCE of 14%.
Does Innospec Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Innospec's ROCE is meaningfully higher than the 8.9% average in the Chemicals 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. Independently of how Innospec compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
Our data shows that Innospec currently has an ROCE of 14%, compared to its ROCE of 10% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly. You can click on the image below to see (in greater detail) how Innospec's past growth compares to other companies.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Since the future is so important for investors, you should check out our free report on analyst forecasts for Innospec.
What Are Current Liabilities, And How Do They Affect Innospec's 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 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Innospec has current liabilities of US$304m and total assets of US$1.5b. Therefore its current liabilities are equivalent to approximately 21% of its total assets. Low current liabilities are not boosting the ROCE too much.
What We Can Learn From Innospec's ROCE
With that in mind, Innospec's ROCE appears pretty good. There might be better investments than Innospec out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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