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Why The L.S. Starrett Company’s (NYSE:SCX) Return On Capital Employed Might Be A Concern

Michael Crabtree

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Today we are going to look at The L.S. Starrett Company (NYSE:SCX) to see whether it might be an attractive investment prospect. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE to similar companies. Then we’ll determine how its current liabilities are affecting its ROCE.

What is 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. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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 L.S. Starrett:

0.051 = US$4.7m ÷ (US$181m – US$26m) (Based on the trailing twelve months to December 2018.)

So, L.S. Starrett has an ROCE of 5.1%.

Check out our latest analysis for L.S. Starrett

Is L.S. Starrett’s ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, L.S. Starrett’s ROCE appears to be significantly below the 12% average in the Machinery industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Regardless of how L.S. Starrett stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). Readers may wish to look for more rewarding investments.

Our data shows that L.S. Starrett currently has an ROCE of 5.1%, compared to its ROCE of 2.9% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly.

NYSE:SCX Last Perf February 7th 19

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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. If L.S. Starrett is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect L.S. Starrett’s 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.

L.S. Starrett has total liabilities of US$26m and total assets of US$181m. Therefore its current liabilities are equivalent to approximately 14% of its total assets. This is not a high level of current liabilities, which would not boost the ROCE by much.

What We Can Learn From L.S. Starrett’s ROCE

That’s not a bad thing, however L.S. Starrett has a weak ROCE and may not be an attractive investment. But note: L.S. Starrett may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.