Today we'll evaluate Guan Chao Holdings Limited (HKG:1872) to determine whether it could have potential as an investment idea. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. 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 Guan Chao Holdings:
0.11 = S$7.3m ÷ (S$103m - S$38m) (Based on the trailing twelve months to June 2019.)
So, Guan Chao Holdings has an ROCE of 11%.
Does Guan Chao Holdings Have A Good ROCE?
One way to assess ROCE is to compare similar companies. We can see Guan Chao Holdings's ROCE is around the 12% average reported by the Specialty Retail industry. Independently of how Guan Chao Holdings compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
We can see that, Guan Chao Holdings currently has an ROCE of 11%, less than the 48% it reported 3 years ago. This makes us wonder if the business is facing new challenges. You can see in the image below how Guan Chao Holdings's ROCE compares to its industry. Click to see more on past growth.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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. If Guan Chao Holdings is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
How Guan Chao Holdings'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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Guan Chao Holdings has total liabilities of S$38m and total assets of S$103m. As a result, its current liabilities are equal to approximately 37% of its total assets. With this level of current liabilities, Guan Chao Holdings's ROCE is boosted somewhat.
What We Can Learn From Guan Chao Holdings's ROCE
With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. There might be better investments than Guan Chao Holdings 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.
I will like Guan Chao Holdings better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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