Today we'll evaluate Yuanda China Holdings Limited (HKG:2789) 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.
First, we'll go over how we calculate ROCE. 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. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. 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'.
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 Yuanda China Holdings:
0.038 = CN¥116m ÷ (CN¥9.4b - CN¥6.4b) (Based on the trailing twelve months to June 2019.)
Therefore, Yuanda China Holdings has an ROCE of 3.8%.
Does Yuanda China Holdings Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. In this analysis, Yuanda China Holdings's ROCE appears meaningfully below the 5.8% average reported by the Building industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Independently of how Yuanda China Holdings compares to its industry, its ROCE in absolute terms is low; especially compared to the ~2.0% available in government bonds. Readers may wish to look for more rewarding investments.
Yuanda China Holdings reported an ROCE of 3.8% -- better than 3 years ago, when the company didn't make a profit. This makes us wonder if the company is improving. The image below shows how Yuanda China Holdings's ROCE compares to its industry, and you can click it to see more detail on its past growth.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is Yuanda China Holdings? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Do Yuanda China Holdings's Current Liabilities Skew Its ROCE?
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Yuanda China Holdings has total assets of CN¥9.4b and current liabilities of CN¥6.4b. Therefore its current liabilities are equivalent to approximately 68% of its total assets. This is a fairly high level of current liabilities, boosting Yuanda China Holdings's ROCE.
What We Can Learn From Yuanda China Holdings's ROCE
Yuanda China Holdings's ROCE in absolute terms is poor, and there are likely better investment prospects out there. Of course, you might also be able to find a better stock than Yuanda China Holdings. So you may wish to see this free collection of other companies that have grown earnings strongly.
There are plenty of other companies that have insiders buying up shares. You probably do not want to miss this free list of growing companies that insiders are buying.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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. Thank you for reading.