Why Digital China Holdings Limited’s (HKG:861) Return On Capital Employed Might Be A Concern

Today we'll look at Digital China Holdings Limited (HKG:861) and reflect on its potential as an investment. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. Then we'll determine how its current liabilities are affecting 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. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that 'one dollar invested in the company generates value of more than one dollar'.

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 Digital China Holdings:

0.016 = HK$251m ÷ (HK$25b - HK$9.9b) (Based on the trailing twelve months to June 2019.)

Therefore, Digital China Holdings has an ROCE of 1.6%.

Check out our latest analysis for Digital China Holdings

Is Digital China Holdings's ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. In this analysis, Digital China Holdings's ROCE appears meaningfully below the 11% average reported by the IT 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 Digital China Holdings stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). There are potentially more appealing investments elsewhere.

Digital China Holdings's current ROCE of 1.6% is lower than its ROCE in the past, which was 3.0%, 3 years ago. Therefore we wonder if the company is facing new headwinds. You can see in the image below how Digital China Holdings's ROCE compares to its industry. Click to see more on past growth.

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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Digital China Holdings.

How Digital China Holdings's Current Liabilities Impact 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.

Digital China Holdings has total liabilities of HK$9.9b and total assets of HK$25b. Therefore its current liabilities are equivalent to approximately 39% of its total assets. Digital China Holdings has a medium level of current liabilities (boosting the ROCE somewhat), and a low ROCE.

The Bottom Line On Digital China Holdings's ROCE

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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.