Today we’ll evaluate Sinotruk (Hong Kong) Limited (HKG:3808) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE 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 measures the amount of pre-tax profits a company can generate from the capital employed 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?

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 Sinotruk (Hong Kong):

0.19 = CN¥4.1b ÷ (CN¥67b – CN¥40b) (Based on the trailing twelve months to June 2018.)

Therefore, Sinotruk (Hong Kong) has an ROCE of 19%.

See our latest analysis for Sinotruk (Hong Kong)

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Does Sinotruk (Hong Kong) Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Sinotruk (Hong Kong)’s ROCE is meaningfully higher than the 10% average in the Machinery industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of where Sinotruk (Hong Kong) sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

Our data shows that Sinotruk (Hong Kong) currently has an ROCE of 19%, compared to its ROCE of 3.4% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly.

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. ROCE is, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

What Are Current Liabilities, And How Do They Affect Sinotruk (Hong Kong)’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 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Sinotruk (Hong Kong) has total assets of CN¥67b and current liabilities of CN¥40b. As a result, its current liabilities are equal to approximately 60% of its total assets. This is admittedly a high level of current liabilities, improving ROCE substantially.

The Bottom Line On Sinotruk (Hong Kong)’s ROCE

The ROCE would not look as appealing if the company had fewer current liabilities. But note: Sinotruk (Hong Kong) may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio 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).

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.