Today we'll evaluate Fountain Set (Holdings) Limited (HKG:420) to determine whether it could have potential as an investment idea. Specifically, we'll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.

First of all, we'll work out how to 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 is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. 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 Fountain Set (Holdings):

0.08 = HK$330m ÷ (HK$5.7b - HK$1.6b) (Based on the trailing twelve months to June 2019.)

So, Fountain Set (Holdings) has an ROCE of 8.0%.

See our latest analysis for Fountain Set (Holdings)

Does Fountain Set (Holdings) Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. It appears that Fountain Set (Holdings)'s ROCE is fairly close to the Luxury industry average of 9.6%. Separate from how Fountain Set (Holdings) stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.

You can click on the image below to see (in greater detail) how Fountain Set (Holdings)'s past growth compares to other companies.

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, after all, simply a snap shot of a single year. You can check if Fountain Set (Holdings) has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect Fountain Set (Holdings)'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. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counter this, investors can check if a company has high current liabilities relative to total assets.

Fountain Set (Holdings) has total liabilities of HK$1.6b and total assets of HK$5.7b. As a result, its current liabilities are equal to approximately 28% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

What We Can Learn From Fountain Set (Holdings)'s ROCE

With that in mind, we're not overly impressed with Fountain Set (Holdings)'s ROCE, so it may not be the most appealing prospect. But note: make sure you look for a great company, not just the first idea you come across. 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 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.