Today we'll evaluate Hengan International Group Company Limited (HKG:1044) to determine whether it could have potential as an investment idea. 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. Then we'll determine how its current liabilities are affecting its ROCE.
Understanding Return On Capital Employed (ROCE)
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. Overall, it is a valuable metric that has its flaws. 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 Hengan International Group:
0.22 = CN¥4.8b ÷ (CN¥45b - CN¥24b) (Based on the trailing twelve months to June 2019.)
Therefore, Hengan International Group has an ROCE of 22%.
Is Hengan International Group's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Hengan International Group's ROCE is meaningfully higher than the 11% average in the Personal Products industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Putting aside its position relative to its industry for now, in absolute terms, Hengan International Group's ROCE is currently very good.
We can see that, Hengan International Group currently has an ROCE of 22%, less than the 32% it reported 3 years ago. This makes us wonder if the business is facing new challenges. You can see in the image below how Hengan International Group'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. 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. Since the future is so important for investors, you should check out our free report on analyst forecasts for Hengan International Group.
Do Hengan International Group's Current Liabilities Skew 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Hengan International Group has total assets of CN¥45b and current liabilities of CN¥24b. As a result, its current liabilities are equal to approximately 52% of its total assets. Hengan International Group's high level of current liabilities boost the ROCE - but its ROCE is still impressive.
What We Can Learn From Hengan International Group's ROCE
So we would be interested in doing more research here -- there may be an opportunity! Hengan International Group 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.
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If you spot an error that warrants correction, please contact the editor at email@example.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.