Today we’ll look at China Sunshine Paper Holdings Company Limited (HKG:2002) and reflect on its potential as an investment. To be precise, we’ll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

Firstly, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.

Return On Capital Employed (ROCE): What is it?

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 brief, it is a useful tool, but it is not without drawbacks. 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 China Sunshine Paper Holdings:

0.21 = CN¥681m ÷ (CN¥9.3b – CN¥6.0b) (Based on the trailing twelve months to June 2018.)

Therefore, China Sunshine Paper Holdings has an ROCE of 21%.

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Is China Sunshine Paper Holdings’s ROCE Good?

One way to assess ROCE is to compare similar companies. China Sunshine Paper Holdings’s ROCE appears to be substantially greater than the 13% average in the Packaging industry. I think that’s good to see, since it implies the company is better than other companies at making the most of its capital. Regardless of the industry comparison, in absolute terms, China Sunshine Paper Holdings’s ROCE currently appears to be excellent.

As we can see, China Sunshine Paper Holdings currently has an ROCE of 21% compared to its ROCE 3 years ago, which was 13%. This makes us think the business might be improving.

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is, after all, simply a snap shot of a single year. If China Sunshine Paper Holdings is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.

Do China Sunshine Paper Holdings’s Current Liabilities Skew Its ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

China Sunshine Paper Holdings has total assets of CN¥9.3b and current liabilities of CN¥6.0b. Therefore its current liabilities are equivalent to approximately 65% of its total assets. While a high level of current liabilities boosts its ROCE, China Sunshine Paper Holdings’s returns are still very good.

The Bottom Line On China Sunshine Paper Holdings’s ROCE

So we would be interested in doing more research here — there may be an opportunity! 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.

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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.