Today we'll evaluate Huaxi Holdings Company Limited (HKG:1689) to determine whether it could have potential as an investment idea. 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, 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.

Return On Capital Employed (ROCE): What is it?

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. 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.

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 Huaxi Holdings:

0.15 = HK$58m ÷ (HK$485m - HK$108m) (Based on the trailing twelve months to March 2019.)

Therefore, Huaxi Holdings has an ROCE of 15%.

Check out our latest analysis for Huaxi Holdings

Is Huaxi Holdings's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. Using our data, Huaxi Holdings's ROCE appears to be around the 13% average of the Packaging industry. Independently of how Huaxi Holdings compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

The image below shows how Huaxi Holdings's ROCE compares to its industry, and you can click it to see more detail on its past growth.

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. How cyclical is Huaxi Holdings? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

Do Huaxi Holdings's Current Liabilities Skew 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.