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Today we'll look at China XD Plastics Company Limited (NASDAQ:CXDC) and reflect on its potential as an investment. 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.
Understanding 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. All else being equal, a better business will have a higher ROCE. In brief, it is a useful tool, but it is not without drawbacks. 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'.
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 XD Plastics:
0.082 = US$104m ÷ (US$2.9b - US$1.6b) (Based on the trailing twelve months to March 2019.)
So, China XD Plastics has an ROCE of 8.2%.
Does China XD Plastics Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. In this analysis, China XD Plastics's ROCE appears meaningfully below the 16% average reported by the Auto Components industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Setting aside the industry comparison for now, China XD Plastics's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
We can see that , China XD Plastics currently has an ROCE of 8.2%, less than the 12% it reported 3 years ago. So investors might consider if it has had issues recently. You can click on the image below to see (in greater detail) how China XD Plastics's past growth compares to other companies.
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. If China XD Plastics is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
How China XD Plastics'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 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
China XD Plastics has total liabilities of US$1.6b and total assets of US$2.9b. As a result, its current liabilities are equal to approximately 56% of its total assets. With a high level of current liabilities, China XD Plastics will experience a boost to its ROCE.
What We Can Learn From China XD Plastics's ROCE
Notably, it also has a mediocre ROCE, which to my mind is not an appealing combination. You might be able to find a better investment than China XD Plastics. 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).
I will like China XD Plastics better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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 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.