Today we are going to look at Escorts Limited (NSE:ESCORTS) 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 up, we'll look at what ROCE is and how we calculate it. 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. Overall, it is a valuable metric that has its flaws. 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?

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 Escorts:

0.19 = ₹5.6b ÷ (₹46b - ₹17b) (Based on the trailing twelve months to September 2019.)

So, Escorts has an ROCE of 19%.

See our latest analysis for Escorts

Is Escorts's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. Escorts's ROCE appears to be substantially greater than the 13% average in the Machinery industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Separate from Escorts's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

In our analysis, Escorts's ROCE appears to be 19%, compared to 3 years ago, when its ROCE was 11%. This makes us think the business might be improving. You can see in the image below how Escorts's ROCE compares to its industry. Click to see more on 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 Escorts.

Do Escorts's Current Liabilities Skew Its ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.