Here’s why Skyworth Digital Holdings Limited’s (HKG:751) Returns On Capital Matters So Much

Today we'll look at Skyworth Digital Holdings Limited (HKG:751) and reflect on its potential as an investment. Specifically, we'll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.

Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. 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. In the end, ROCE 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.'

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 Skyworth Digital Holdings:

0.029 = HK$236m ÷ (HK$50b - HK$24b) (Based on the trailing twelve months to September 2018.)

Therefore, Skyworth Digital Holdings has an ROCE of 2.9%.

View our latest analysis for Skyworth Digital Holdings

Does Skyworth Digital Holdings Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, Skyworth Digital Holdings's ROCE appears to be significantly below the 9.9% average in the Consumer Durables industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Regardless of how Skyworth Digital Holdings stacks up against its industry, its ROCE in absolute terms is quite low (not much higher than a bank account). It is likely that there are more attractive prospects out there.

Skyworth Digital Holdings's current ROCE of 2.9% is lower than its ROCE in the past, which was 8.7%, 3 years ago. This makes us wonder if the business is facing new challenges.

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Since the future is so important for investors, you should check out our freereport on analyst forecasts for Skyworth Digital Holdings.

What Are Current Liabilities, And How Do They Affect Skyworth Digital Holdings's ROCE?

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

Skyworth Digital Holdings has total assets of HK$50b and current liabilities of HK$24b. Therefore its current liabilities are equivalent to approximately 48% of its total assets. With a medium level of current liabilities boosting the ROCE a little, Skyworth Digital Holdings's low ROCE is unappealing.

The Bottom Line On Skyworth Digital Holdings's ROCE

This company may not be the most attractive investment prospect. A higher ROCE is usually more attractive, but even a weaker business with the right price and opportunities can make a good investment. So it might be wise to check if insiders have been buying.

But note: Skyworth Digital Holdings may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.