Today we’ll evaluate Chongqing Machinery & Electric Co., Ltd. (HKG:2722) 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. And finally, we’ll look at how its current liabilities are impacting 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. Ultimately, it is a useful but imperfect metric. 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?
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 Chongqing Machinery & Electric:
0.0058 = CN¥56m ÷ (CN¥16b – CN¥6.7b) (Based on the trailing twelve months to December 2018.)
Therefore, Chongqing Machinery & Electric has an ROCE of 0.6%.
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Does Chongqing Machinery & Electric Have A Good ROCE?
One way to assess ROCE is to compare similar companies. Using our data, Chongqing Machinery & Electric’s ROCE appears to be significantly below the 3.7% average in the Industrials industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Regardless of how Chongqing Machinery & Electric stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). There are potentially more appealing investments elsewhere.
Chongqing Machinery & Electric reported an ROCE of 0.6% — 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. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is Chongqing Machinery & Electric? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
How Chongqing Machinery & Electric’s Current Liabilities Impact Its ROCE
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counter this, investors can check if a company has high current liabilities relative to total assets.
Chongqing Machinery & Electric has total assets of CN¥16b and current liabilities of CN¥6.7b. As a result, its current liabilities are equal to approximately 41% of its total assets. Chongqing Machinery & Electric has a medium level of current liabilities (boosting the ROCE somewhat), and a low ROCE.
What We Can Learn From Chongqing Machinery & Electric’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.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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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. Thank you for reading.