Is Li Ning Company Limited’s (HKG:2331) 9.6% Return On Capital Employed Good News?

Lee Kay

Mon, Feb 4, 2019, 7:28 PM

Today we’ll evaluate Li Ning Company Limited (HKG:2331) 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 up, we’ll look at what ROCE is and how we calculate it. Then we’ll compare its ROCE to similar companies. Then we’ll determine how its current liabilities are affecting its ROCE.

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

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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?

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 Li Ning:

0.096 = CN¥446m ÷ (CN¥8.0b – CN¥2.5b) (Based on the trailing twelve months to June 2018.)

So, Li Ning has an ROCE of 9.6%.

View our latest analysis for Li Ning

Is Li Ning’s ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. We can see Li Ning’s ROCE is around the 9.4% average reported by the Luxury industry. Setting aside the industry comparison for now, Li Ning’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.

Li Ning delivered an ROCE of 9.6%, which is better than 3 years ago, as was making losses back then. That implies the business has been improving.

Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. 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 Li Ning.

How Li Ning’s Current Liabilities Impact Its ROCE

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. 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 counter this, investors can check if a company has high current liabilities relative to total assets.