Today we are going to look at Sterling Tools Limited (NSE:STERTOOLS) to see whether it might be an attractive investment prospect. 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. And finally, we'll look at how its current liabilities are impacting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'

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 Sterling Tools:

0.18 = ₹669m ÷ (₹4.6b - ₹881m) (Based on the trailing twelve months to March 2019.)

So, Sterling Tools has an ROCE of 18%.

View our latest analysis for Sterling Tools

Is Sterling Tools's ROCE Good?

One way to assess ROCE is to compare similar companies. We can see Sterling Tools's ROCE is around the 16% average reported by the Auto Components industry. Regardless of where Sterling Tools sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

We can see that , Sterling Tools currently has an ROCE of 18%, less than the 29% it reported 3 years ago. This makes us wonder if the business is facing new challenges. The image below shows how Sterling Tools's ROCE compares to its industry, and you can click it to see more detail on its past growth.

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 Sterling Tools.

How Sterling Tools's Current Liabilities Impact 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. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Sterling Tools has total liabilities of ₹881m and total assets of ₹4.6b. Therefore its current liabilities are equivalent to approximately 19% of its total assets. Low current liabilities are not boosting the ROCE too much.

Our Take On Sterling Tools's ROCE

Overall, Sterling Tools has a decent ROCE and could be worthy of further research. Sterling Tools 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.

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

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.

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. Thank you for reading.