Today we'll look at Dragon Mining Limited (HKG:1712) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

First up, we'll look at what ROCE is and how we calculate it. 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. Generally speaking a higher ROCE is better. 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?

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 Dragon Mining:

0.084 = AU$5.8m ÷ (AU$79m - AU$9.6m) (Based on the trailing twelve months to December 2019.)

Therefore, Dragon Mining has an ROCE of 8.4%.

Check out our latest analysis for Dragon Mining

Does Dragon Mining Have A Good ROCE?

One way to assess ROCE is to compare similar companies. We can see Dragon Mining's ROCE is around the 7.1% average reported by the Metals and Mining industry. Aside from the industry comparison, Dragon Mining's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

Dragon Mining's current ROCE of 8.4% is lower than 3 years ago, when the company reported a 12% ROCE. This makes us wonder if the business is facing new challenges. You can see in the image below how Dragon Mining'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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Given the industry it operates in, Dragon Mining could be considered cyclical. You can check if Dragon Mining has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.

Dragon Mining's Current Liabilities And Their Impact On 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Dragon Mining has current liabilities of AU$9.6m and total assets of AU$79m. Therefore its current liabilities are equivalent to approximately 12% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

Our Take On Dragon Mining's ROCE

If Dragon Mining continues to earn an uninspiring ROCE, there may be better places to invest. You might be able to find a better investment than Dragon Mining. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.