Today we are going to look at Lonking Holdings Limited (HKG:3339) to see whether it might be an attractive investment prospect. 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.
What is Return On Capital Employed (ROCE)?
ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. 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'.
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 Lonking Holdings:
0.14 = CN¥1.3b ÷ (CN¥14b - CN¥4.5b) (Based on the trailing twelve months to December 2018.)
So, Lonking Holdings has an ROCE of 14%.
Does Lonking Holdings Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. Lonking Holdings's ROCE appears to be substantially greater than the 11% average in the Machinery industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Separate from Lonking Holdings's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
We can see that , Lonking Holdings currently has an ROCE of 14% compared to its ROCE 3 years ago, which was 3.0%. This makes us think the business might be improving. The image below shows how Lonking Holdings's ROCE compares to its industry, and you can click it to see more detail on its past growth.
It is important to remember that ROCE shows past performance, and is 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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Lonking Holdings.
How Lonking Holdings'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.
Lonking Holdings has total assets of CN¥14b and current liabilities of CN¥4.5b. As a result, its current liabilities are equal to approximately 32% of its total assets. Lonking Holdings has a middling amount of current liabilities, increasing its ROCE somewhat.
Our Take On Lonking Holdings's ROCE
Lonking Holdings's ROCE does look good, but the level of current liabilities also contribute to that. There might be better investments than Lonking 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.
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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.