Today we'll look at Hon Corporation Limited (HKG:8259) 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.
First up, we'll look at what ROCE is and how we calculate it. Next, we'll compare it to others in its industry. And finally, we'll look at how its current liabilities are impacting its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. 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 Hon:
0.13 = S$3.4m ÷ (S$77m - S$49m) (Based on the trailing twelve months to June 2019.)
Therefore, Hon has an ROCE of 13%.
Is Hon's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. It appears that Hon's ROCE is fairly close to the Construction industry average of 12%. Regardless of where Hon sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
You can click on the image below to see (in greater detail) how Hon'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. ROCE is only a point-in-time measure. If Hon is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
How Hon's Current Liabilities Impact 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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Hon has total assets of S$77m and current liabilities of S$49m. As a result, its current liabilities are equal to approximately 64% of its total assets. Hon has a relatively high level of current liabilities, boosting its ROCE meaningfully.
What We Can Learn From Hon's ROCE
The ROCE would not look as appealing if the company had fewer current liabilities. Hon shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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