Today we are going to look at China XD Plastics Company Limited (NASDAQ:CXDC) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed 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. 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 XD Plastics:
0.10 = US$139m ÷ (US$2.8b - US$1.4b) (Based on the trailing twelve months to September 2019.)
So, China XD Plastics has an ROCE of 10%.
Is China XD Plastics's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. We can see China XD Plastics's ROCE is meaningfully below the Auto Components industry average of 15%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Separate from China XD Plastics's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
China XD Plastics's current ROCE of 10% is lower than 3 years ago, when the company reported a 15% ROCE. Therefore we wonder if the company is facing new headwinds. You can see in the image below how China XD Plastics'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. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is, after all, simply a snap shot of a single year. How cyclical is China XD Plastics? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Do China XD Plastics'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. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counter this, investors can check if a company has high current liabilities relative to total assets.
China XD Plastics has total liabilities of US$1.4b and total assets of US$2.8b. As a result, its current liabilities are equal to approximately 51% of its total assets. China XD Plastics's current liabilities are fairly high, which increases its ROCE significantly.
The Bottom Line On China XD Plastics's ROCE
This ROCE is pretty good, but remember that it would look less impressive with fewer current liabilities. There might be better investments than China XD Plastics out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
There are plenty of other companies that have insiders buying up shares. You probably do not want to miss this free list of growing companies that insiders are buying.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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