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Today we'll look at Kunming Dianchi Water Treatment Co., Ltd. (HKG:3768) and reflect on its potential as an investment. 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.

Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Finally, we'll look at how its current liabilities affect 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. Generally speaking a higher ROCE is better. 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?

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 Kunming Dianchi Water Treatment:

0.08 = CN¥477m ÷ (CN¥7.4b - CN¥1.5b) (Based on the trailing twelve months to December 2018.)

Therefore, Kunming Dianchi Water Treatment has an ROCE of 8.0%.

See our latest analysis for Kunming Dianchi Water Treatment

Is Kunming Dianchi Water Treatment's ROCE Good?

One way to assess ROCE is to compare similar companies. We can see Kunming Dianchi Water Treatment's ROCE is around the 7.6% average reported by the Water Utilities industry. Separate from how Kunming Dianchi Water Treatment stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.

The image below shows how Kunming Dianchi Water Treatment's ROCE compares to its industry, and you can click it to see more detail on its past growth.

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 deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. If Kunming Dianchi Water Treatment is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect Kunming Dianchi Water Treatment's ROCE?

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Kunming Dianchi Water Treatment has total assets of CN¥7.4b and current liabilities of CN¥1.5b. Therefore its current liabilities are equivalent to approximately 20% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

The Bottom Line On Kunming Dianchi Water Treatment's ROCE

If Kunming Dianchi Water Treatment continues to earn an uninspiring ROCE, there may be better places to invest. 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).

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.

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. Thank you for reading.