Should You Like InnovaDerma PLC’s (LON:IDP) High Return On Capital Employed?

Today we'll look at InnovaDerma PLC (LON:IDP) and reflect on its potential as an investment. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

Return On Capital Employed (ROCE): What is it?

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'.

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 InnovaDerma:

0.15 = UK£1.5m ÷ (UK£14m - UK£3.4m) (Based on the trailing twelve months to December 2019.)

So, InnovaDerma has an ROCE of 15%.

Check out our latest analysis for InnovaDerma

Is InnovaDerma's ROCE Good?

One way to assess ROCE is to compare similar companies. In our analysis, InnovaDerma's ROCE is meaningfully higher than the 12% average in the Personal Products industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Regardless of where InnovaDerma sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

In our analysis, InnovaDerma's ROCE appears to be 15%, compared to 3 years ago, when its ROCE was 2.7%. This makes us think the business might be improving. You can see in the image below how InnovaDerma's ROCE compares to its industry. Click to see more on past growth.

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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 only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for InnovaDerma.

InnovaDerma's Current Liabilities And Their Impact On Its 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 the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counteract this, we check if a company has high current liabilities, relative to its total assets.

InnovaDerma has total assets of UK£14m and current liabilities of UK£3.4m. As a result, its current liabilities are equal to approximately 25% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.

The Bottom Line On InnovaDerma's ROCE

With that in mind, InnovaDerma's ROCE appears pretty good. InnovaDerma 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.

There are plenty of other companies that have insiders buying up shares. You probably do not want to miss this free list of growing companies that insiders are buying.

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.

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. Thank you for reading.