Today we'll evaluate China Petroleum & Chemical Corporation (HKG:386) to determine whether it could have potential as an investment idea. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
What is 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. All else being equal, a better business will have a higher ROCE. Overall, it 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.
How Do You Calculate Return On Capital Employed?
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 China Petroleum & Chemical:
0.05 = CN¥61b ÷ (CN¥1.8t - CN¥598b) (Based on the trailing twelve months to September 2019.)
Therefore, China Petroleum & Chemical has an ROCE of 5.0%.
Is China Petroleum & Chemical's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, China Petroleum & Chemical's ROCE appears to be significantly below the 7.5% average in the Oil and Gas industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Regardless of how China Petroleum & Chemical stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). It is likely that there are more attractive prospects out there.
You can see in the image below how China Petroleum & Chemical's ROCE compares to its industry.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. Remember that most companies like China Petroleum & Chemical are cyclical businesses. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for China Petroleum & Chemical.
Do China Petroleum & Chemical's Current Liabilities Skew Its 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 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.
China Petroleum & Chemical has total liabilities of CN¥598b and total assets of CN¥1.8t. Therefore its current liabilities are equivalent to approximately 33% of its total assets. In light of sufficient current liabilities to noticeably boost the ROCE, China Petroleum & Chemical's ROCE is concerning.
What We Can Learn From China Petroleum & Chemical's ROCE
There are likely better investments out there. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
I will like China Petroleum & Chemical better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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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.