Today we'll evaluate Spectra Systems Corporation (LON:SPSC) to determine whether it could have potential as an investment idea. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the 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 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'.
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 Spectra Systems:
0.15 = US$3.9m ÷ (US$28m - US$1.8m) (Based on the trailing twelve months to December 2018.)
So, Spectra Systems has an ROCE of 15%.
Does Spectra Systems Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that Spectra Systems's ROCE is meaningfully better than the 12% average in the Electronic 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 Spectra Systems sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
Spectra Systems has an ROCE of 15%, but it didn't have an ROCE 3 years ago, since it was unprofitable. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how Spectra Systems's past growth compares to other companies.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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. Since the future is so important for investors, you should check out our free report on analyst forecasts for Spectra Systems.
How Spectra Systems'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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Spectra Systems has total assets of US$28m and current liabilities of US$1.8m. Therefore its current liabilities are equivalent to approximately 6.4% of its total assets. In addition to low current liabilities (making a negligible impact on ROCE), Spectra Systems earns a sound return on capital employed.
Our Take On Spectra Systems's ROCE
If it is able to keep this up, Spectra Systems could be attractive. Spectra Systems 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.
I will like Spectra Systems 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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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. Thank you for reading.