Today we'll evaluate Jiangnan Group Limited (HKG:1366) 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 up, we'll look at what ROCE is and how we calculate it. 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 measures the 'return' (pre-tax profit) a company generates from capital employed in its 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.
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 Jiangnan Group:
0.13 = CN¥731m ÷ (CN¥15b - CN¥9.4b) (Based on the trailing twelve months to June 2019.)
So, Jiangnan Group has an ROCE of 13%.
Does Jiangnan Group Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Jiangnan Group's ROCE is meaningfully higher than the 8.1% average in the Electrical industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Independently of how Jiangnan Group compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
We can see that, Jiangnan Group currently has an ROCE of 13%, less than the 20% it reported 3 years ago. So investors might consider if it has had issues recently. You can see in the image below how Jiangnan Group's ROCE compares to its industry. Click to see more on past growth.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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. If Jiangnan Group is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
Do Jiangnan Group's Current Liabilities Skew Its ROCE?
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Jiangnan Group has total assets of CN¥15b and current liabilities of CN¥9.4b. Therefore its current liabilities are equivalent to approximately 63% of its total assets. Jiangnan Group has a relatively high level of current liabilities, boosting its ROCE meaningfully.
The Bottom Line On Jiangnan Group's ROCE
The ROCE would not look as appealing if the company had fewer current liabilities. Jiangnan 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.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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.
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