Today we’ll evaluate Zhongyu Gas Holdings Limited (HKG:3633) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First of all, we’ll work out how to calculate ROCE. Next, we’ll compare it to others in its industry. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
Understanding 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. 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.
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 Zhongyu Gas Holdings:
0.11 = HK$1.6b ÷ (HK$20b – HK$6.1b) (Based on the trailing twelve months to June 2019.)
So, Zhongyu Gas Holdings has an ROCE of 11%.
Does Zhongyu Gas Holdings Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Zhongyu Gas Holdings’s ROCE is meaningfully higher than the 9.4% average in the Gas Utilities industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Separate from Zhongyu Gas Holdings’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
You can click on the image below to see (in greater detail) how Zhongyu Gas Holdings’s past growth compares to other companies.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is Zhongyu Gas Holdings? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
How Zhongyu Gas Holdings’s Current Liabilities Impact Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.
Zhongyu Gas Holdings has total assets of HK$20b and current liabilities of HK$6.1b. As a result, its current liabilities are equal to approximately 31% of its total assets. With this level of current liabilities, Zhongyu Gas Holdings’s ROCE is boosted somewhat.
What We Can Learn From Zhongyu Gas Holdings’s ROCE
Zhongyu Gas Holdings’s ROCE does look good, but the level of current liabilities also contribute to that. Zhongyu Gas Holdings shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
If you are like me, then you will 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 firstname.lastname@example.org. 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.
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