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What Can We Make Of Smith & Nephew plc’s (LON:SN.) High Return On Capital?

Simply Wall St

Today we'll look at Smith & Nephew plc (LON:SN.) and reflect on its potential as an investment. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. 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. 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?

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 Smith & Nephew:

0.14 = US$1.0b ÷ (US$8.9b - US$1.5b) (Based on the trailing twelve months to June 2019.)

So, Smith & Nephew has an ROCE of 14%.

See our latest analysis for Smith & Nephew

Does Smith & Nephew Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. Smith & Nephew's ROCE appears to be substantially greater than the 11% average in the Medical Equipment industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Independently of how Smith & Nephew compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

You can see in the image below how Smith & Nephew's ROCE compares to its industry. Click to see more on past growth.

LSE:SN. Past Revenue and Net Income, December 6th 2019

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

How Smith & Nephew's Current Liabilities Impact 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 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.

Smith & Nephew has total assets of US$8.9b and current liabilities of US$1.5b. As a result, its current liabilities are equal to approximately 16% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.

What We Can Learn From Smith & Nephew's ROCE

With that in mind, Smith & Nephew's ROCE appears pretty good. Smith & Nephew shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.

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. Thank you for reading.