Today we'll look at Cosmos Machinery Enterprises Limited (HKG:118) 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, 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. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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 Cosmos Machinery Enterprises:
0.035 = HK$51m ÷ (HK$2.8b - HK$1.3b) (Based on the trailing twelve months to June 2019.)
Therefore, Cosmos Machinery Enterprises has an ROCE of 3.5%.
Is Cosmos Machinery Enterprises's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. We can see Cosmos Machinery Enterprises's ROCE is meaningfully below the Machinery industry average of 11%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Putting aside Cosmos Machinery Enterprises's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. There are potentially more appealing investments elsewhere.
Cosmos Machinery Enterprises delivered an ROCE of 3.5%, which is better than 3 years ago, as was making losses back then. That implies the business has been improving. The image below shows how Cosmos Machinery Enterprises's ROCE compares to its industry, and you can click it to see more detail on its past growth.
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 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. If Cosmos Machinery Enterprises is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect Cosmos Machinery Enterprises's ROCE?
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Cosmos Machinery Enterprises has total assets of HK$2.8b and current liabilities of HK$1.3b. Therefore its current liabilities are equivalent to approximately 47% of its total assets. In light of sufficient current liabilities to noticeably boost the ROCE, Cosmos Machinery Enterprises's ROCE is concerning.
The Bottom Line On Cosmos Machinery Enterprises's ROCE
This company may not be the most attractive investment prospect. 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.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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.
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