Today we are going to look at Weichai Power Co., Ltd. (HKG:2338) 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.
Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
What is 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. 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 Weichai Power:
0.11 = CN¥14b ÷ (CN¥224b - CN¥96b) (Based on the trailing twelve months to September 2019.)
Therefore, Weichai Power has an ROCE of 11%.
Is Weichai Power's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. We can see Weichai Power's ROCE is around the 11% average reported by the Machinery industry. Independently of how Weichai Power compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
In our analysis, Weichai Power's ROCE appears to be 11%, compared to 3 years ago, when its ROCE was 5.2%. This makes us wonder if the company is improving. You can see in the image below how Weichai Power'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. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. Since the future is so important for investors, you should check out our free report on analyst forecasts for Weichai Power.
What Are Current Liabilities, And How Do They Affect Weichai Power's ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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.
Weichai Power has total liabilities of CN¥96b and total assets of CN¥224b. As a result, its current liabilities are equal to approximately 43% of its total assets. Weichai Power has a medium level of current liabilities, which would boost the ROCE.
What We Can Learn From Weichai Power's ROCE
While its ROCE looks good, it's worth remembering that the current liabilities are making the business look better. Weichai Power shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
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 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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