Today we are going to look at Xiwang Special Steel Company Limited (HKG:1266) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
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.
Understanding Return On Capital Employed (ROCE)
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed 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.
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 Xiwang Special Steel:
0.13 = CN¥930m ÷ (CN¥14b - CN¥7.4b) (Based on the trailing twelve months to June 2019.)
So, Xiwang Special Steel has an ROCE of 13%.
Is Xiwang Special Steel's ROCE Good?
One way to assess ROCE is to compare similar companies. Xiwang Special Steel's ROCE appears to be substantially greater than the 7.8% average in the Metals and Mining industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Independently of how Xiwang Special Steel compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
Our data shows that Xiwang Special Steel currently has an ROCE of 13%, compared to its ROCE of 6.1% 3 years ago. This makes us wonder if the company is improving. You can see in the image below how Xiwang Special Steel's ROCE compares to its industry. Click to see more on 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. Remember that most companies like Xiwang Special Steel are cyclical businesses. How cyclical is Xiwang Special Steel? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect Xiwang Special Steel's 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.
Xiwang Special Steel has total assets of CN¥14b and current liabilities of CN¥7.4b. As a result, its current liabilities are equal to approximately 51% of its total assets. Xiwang Special Steel has a relatively high level of current liabilities, boosting its ROCE meaningfully.
The Bottom Line On Xiwang Special Steel's ROCE
The ROCE would not look as appealing if the company had fewer current liabilities. There might be better investments than Xiwang Special Steel 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.
I will like Xiwang Special Steel better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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