Today we are going to look at China Petroleum & Chemical Corporation (HKG:386) to see whether it might be an attractive investment prospect. 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. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.
Understanding 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. 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?
Analysts use this formula to calculate return on capital employed:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
Or for China Petroleum & Chemical:
0.05 = CN¥61b ÷ (CN¥1.8t - CN¥598b) (Based on the trailing twelve months to September 2019.)
Therefore, China Petroleum & Chemical has an ROCE of 5.0%.
Does China Petroleum & Chemical Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. In this analysis, China Petroleum & Chemical's ROCE appears meaningfully below the 8.0% average reported by the Oil and Gas industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Separate from how China Petroleum & Chemical stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.
You can click on the image below to see (in greater detail) how China Petroleum & Chemical's past growth compares to other companies.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Given the industry it operates in, China Petroleum & Chemical could be considered cyclical. Since the future is so important for investors, you should check out our free report on analyst forecasts for China Petroleum & Chemical.
China Petroleum & Chemical's Current Liabilities And Their Impact On 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.
China Petroleum & Chemical has current liabilities of CN¥598b and total assets of CN¥1.8t. As a result, its current liabilities are equal to approximately 33% of its total assets. China Petroleum & Chemical's middling level of current liabilities have the effect of boosting its ROCE a bit.
The Bottom Line On China Petroleum & Chemical's ROCE
Unfortunately, its ROCE is still uninspiring, and there are potentially more attractive prospects out there. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E 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.
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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