Today we'll evaluate Shaanxi Northwest New Technology Industry Company Limited (HKG:8258) to determine whether it could have potential as an investment idea. 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.
First up, we'll look at what ROCE is and how we calculate it. Next, we'll compare it to others in its industry. And finally, we'll look at how its current liabilities are impacting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. In general, businesses with a higher ROCE are usually better quality. 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.'
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 Shaanxi Northwest New Technology Industry:
0.061 = CN¥9.8m ÷ (CN¥171m - CN¥11m) (Based on the trailing twelve months to June 2019.)
So, Shaanxi Northwest New Technology Industry has an ROCE of 6.1%.
Is Shaanxi Northwest New Technology Industry's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. We can see Shaanxi Northwest New Technology Industry's ROCE is meaningfully below the Chemicals industry average of 12%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Separate from how Shaanxi Northwest New Technology Industry stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Readers may find more attractive investment prospects elsewhere.
Our data shows that Shaanxi Northwest New Technology Industry currently has an ROCE of 6.1%, compared to its ROCE of 3.5% 3 years ago. This makes us think the business might be improving. You can see in the image below how Shaanxi Northwest New Technology Industry's ROCE compares to its industry. Click to see more on past growth.
When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. You can check if Shaanxi Northwest New Technology Industry has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Do Shaanxi Northwest New Technology Industry'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 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Shaanxi Northwest New Technology Industry has total assets of CN¥171m and current liabilities of CN¥11m. As a result, its current liabilities are equal to approximately 6.6% of its total assets. With low levels of current liabilities, at least Shaanxi Northwest New Technology Industry's mediocre ROCE is not unduly boosted.
What We Can Learn From Shaanxi Northwest New Technology Industry's ROCE
Based on this information, Shaanxi Northwest New Technology Industry appears to be a mediocre business. You might be able to find a better investment than Shaanxi Northwest New Technology Industry. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
If you are like me, then you will not want to miss this free list of growing companies that insiders are 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.