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Dongguang Chemical Limited (HKG:1702) Earns A Nice Return On Capital Employed

Simply Wall St

Today we'll evaluate Dongguang Chemical Limited (HKG:1702) to determine whether it could have potential as an investment idea. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

First of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. 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 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. 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 Dongguang Chemical:

0.23 = CN¥256m ÷ (CN¥1.9b - CN¥759m) (Based on the trailing twelve months to June 2019.)

So, Dongguang Chemical has an ROCE of 23%.

See our latest analysis for Dongguang Chemical

Is Dongguang Chemical's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that Dongguang Chemical's ROCE is meaningfully better than the 11% average in the Chemicals industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of the industry comparison, in absolute terms, Dongguang Chemical's ROCE currently appears to be excellent.

You can click on the image below to see (in greater detail) how Dongguang Chemical's past growth compares to other companies.

SEHK:1702 Past Revenue and Net Income, December 19th 2019

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is Dongguang Chemical? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect Dongguang Chemical's ROCE?

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Dongguang Chemical has total assets of CN¥1.9b and current liabilities of CN¥759m. As a result, its current liabilities are equal to approximately 40% of its total assets. Dongguang Chemical's ROCE is boosted somewhat by its middling amount of current liabilities.

The Bottom Line On Dongguang Chemical's ROCE

Despite this, it reports a high ROCE, and may be worth investigating further. Dongguang Chemical looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

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.

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. Thank you for reading.