Today we'll look at InnoTek Limited (SGX:M14) and reflect on its potential as an investment. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.

What is 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. 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'.

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 InnoTek:

0.11 = S$17m ÷ (S$224m - S$71m) (Based on the trailing twelve months to December 2018.)

Therefore, InnoTek has an ROCE of 11%.

View our latest analysis for InnoTek

Is InnoTek's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that InnoTek's ROCE is meaningfully better than the 8.1% average in the Machinery industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how InnoTek compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

InnoTek reported an ROCE of 11% -- better than 3 years ago, when the company didn't make a profit. That suggests the business has returned to profitability.

When considering this metric, keep in mind that it is backwards looking, and 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. ROCE is, after all, simply a snap shot of a single year. If InnoTek 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 InnoTek'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 counteract this, we check if a company has high current liabilities, relative to its total assets.

InnoTek has total liabilities of S$71m and total assets of S$224m. As a result, its current liabilities are equal to approximately 32% of its total assets. InnoTek has a medium level of current liabilities, which would boost the ROCE.

What We Can Learn From InnoTek's ROCE

With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. You might be able to find a better buy than InnoTek. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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

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.