Today we'll evaluate Tata Sponge Iron Limited (NSE:TATASPONGE) 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 of all, we'll work out how to 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. 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?
Analysts use this formula to calculate return on capital employed:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
Or for Tata Sponge Iron:
0.16 = ₹1.7b ÷ (₹12b - ₹1.9b) (Based on the trailing twelve months to December 2018.)
So, Tata Sponge Iron has an ROCE of 16%.
Check out our latest analysis for Tata Sponge Iron
Is Tata Sponge Iron's ROCE Good?
One way to assess ROCE is to compare similar companies. It appears that Tata Sponge Iron's ROCE is fairly close to the Metals and Mining industry average of 16%. Separate from Tata Sponge Iron's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
As we can see, Tata Sponge Iron currently has an ROCE of 16% compared to its ROCE 3 years ago, which was 3.7%. This makes us wonder if the company is improving.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Given the industry it operates in, Tata Sponge Iron could be considered cyclical. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do Tata Sponge Iron's Current Liabilities Skew Its ROCE?
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, 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 counter this, investors can check if a company has high current liabilities relative to total assets.