Today we'll look at Guangdong Kanghua Healthcare Co., Ltd. (HKG:3689) 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.
Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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?
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 Guangdong Kanghua Healthcare:
0.094 = CN¥159m ÷ (CN¥2.5b - CN¥823m) (Based on the trailing twelve months to June 2019.)
Therefore, Guangdong Kanghua Healthcare has an ROCE of 9.4%.
Is Guangdong Kanghua Healthcare's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. It appears that Guangdong Kanghua Healthcare's ROCE is fairly close to the Healthcare industry average of 8.3%. Aside from the industry comparison, Guangdong Kanghua Healthcare'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.
Guangdong Kanghua Healthcare's current ROCE of 9.4% is lower than 3 years ago, when the company reported a 24% ROCE. Therefore we wonder if the company is facing new headwinds. You can click on the image below to see (in greater detail) how Guangdong Kanghua Healthcare's past growth compares to other companies.
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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. If Guangdong Kanghua Healthcare is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
How Guangdong Kanghua Healthcare's Current Liabilities Impact Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.
Guangdong Kanghua Healthcare has total liabilities of CN¥823m and total assets of CN¥2.5b. As a result, its current liabilities are equal to approximately 33% of its total assets. Guangdong Kanghua Healthcare has a medium level of current liabilities, which would boost its ROCE somewhat.
What We Can Learn From Guangdong Kanghua Healthcare's ROCE
With this level of liabilities and a mediocre ROCE, there are potentially better investments out there. 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 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. Thank you for reading.