Today we'll look at Servotronics, Inc. (NYSEMKT:SVT) and reflect on its potential as an investment. 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. 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. In general, businesses with a higher ROCE are usually better quality. 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?
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 Servotronics:
0.11 = US$4.0m ÷ (US$44m - US$7.7m) (Based on the trailing twelve months to June 2019.)
So, Servotronics has an ROCE of 11%.
Is Servotronics's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. We can see Servotronics's ROCE is around the 11% average reported by the Electrical industry. Regardless of where Servotronics sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
You can see in the image below how Servotronics's ROCE compares to its industry. Click to see more on past growth.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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. You can check if Servotronics has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Servotronics's Current Liabilities And Their Impact On Its 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 ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.
Servotronics has total assets of US$44m and current liabilities of US$7.7m. As a result, its current liabilities are equal to approximately 18% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
What We Can Learn From Servotronics's ROCE
This is good to see, and with a sound ROCE, Servotronics could be worth a closer look. There might be better investments than Servotronics 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.
I will like Servotronics better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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