Today we'll look at Sutlej Textiles and Industries Limited (NSE:SUTLEJTEX) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its 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 Sutlej Textiles and Industries:
0.097 = ₹1.4b ÷ (₹22b - ₹7.3b) (Based on the trailing twelve months to March 2018.)
Therefore, Sutlej Textiles and Industries has an ROCE of 9.7%.
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Does Sutlej Textiles and Industries Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, Sutlej Textiles and Industries's ROCE appears to be around the 12% average of the Luxury industry. Independently of how Sutlej Textiles and Industries compares to its industry, its ROCE in absolute terms is low; especially compared to the ~7.6% available in government bonds. It is likely that there are more attractive prospects out there.
Sutlej Textiles and Industries's current ROCE of 9.7% is lower than its ROCE in the past, which was 17%, 3 years ago. This makes us wonder if the business is facing new challenges.
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. ROCE is, after all, simply a snap shot of a single year. You can check if Sutlej Textiles and Industries has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect Sutlej Textiles and Industries's 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Sutlej Textiles and Industries has total liabilities of ₹7.3b and total assets of ₹22b. Therefore its current liabilities are equivalent to approximately 33% of its total assets. Sutlej Textiles and Industries has a medium level of current liabilities (boosting the ROCE somewhat), and a low ROCE.
What We Can Learn From Sutlej Textiles and Industries's ROCE
So researching other companies may be a better use of your time. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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If you spot an error that warrants correction, please contact the editor at email@example.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.