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Don’t Buy China Water Industry Group Limited (HKG:1129) Until You Understand Its ROCE

Simply Wall St

Today we are going to look at China Water Industry Group Limited (HKG:1129) to see whether it might be an attractive investment prospect. 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. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.

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

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. 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 Water Industry Group:

0.061 = HK$167m ÷ (HK$4.0b - HK$1.3b) (Based on the trailing twelve months to June 2019.)

Therefore, China Water Industry Group has an ROCE of 6.1%.

View our latest analysis for China Water Industry Group

Is China Water Industry Group's ROCE Good?

One way to assess ROCE is to compare similar companies. It appears that China Water Industry Group's ROCE is fairly close to the Water Utilities industry average of 7.5%. Separate from how China Water Industry Group stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.

We can see that, China Water Industry Group currently has an ROCE of 6.1% compared to its ROCE 3 years ago, which was 2.1%. This makes us think about whether the company has been reinvesting shrewdly. You can see in the image below how China Water Industry Group's ROCE compares to its industry. Click to see more on past growth.

SEHK:1129 Past Revenue and Net Income, October 21st 2019

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately 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. ROCE is only a point-in-time measure. How cyclical is China Water Industry Group? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

How China Water Industry Group's Current Liabilities Impact Its ROCE

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

China Water Industry Group has total assets of HK$4.0b and current liabilities of HK$1.3b. As a result, its current liabilities are equal to approximately 32% of its total assets. China Water Industry Group has a medium level of current liabilities, which would boost its ROCE somewhat.

Our Take On China Water Industry Group's ROCE

Despite this, its ROCE is still mediocre, and you may find more appealing investments elsewhere. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.