Today we'll evaluate Prosperous Industrial (Holdings) Limited (HKG:1731) 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 of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. And finally, we'll look at how its current liabilities are impacting 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. 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.

So, How Do We Calculate ROCE?

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 Prosperous Industrial (Holdings):

0.032 = US$5.0m ÷ (US$193m - US$41m) (Based on the trailing twelve months to June 2019.)

Therefore, Prosperous Industrial (Holdings) has an ROCE of 3.2%.

See our latest analysis for Prosperous Industrial (Holdings)

Is Prosperous Industrial (Holdings)'s ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. We can see Prosperous Industrial (Holdings)'s ROCE is meaningfully below the Luxury industry average of 9.6%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Regardless of how Prosperous Industrial (Holdings) stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). Readers may wish to look for more rewarding investments.

Prosperous Industrial (Holdings)'s current ROCE of 3.2% is lower than its ROCE in the past, which was 17%, 3 years ago. Therefore we wonder if the company is facing new headwinds. You can see in the image below how Prosperous Industrial (Holdings)'s ROCE compares to its industry. Click to see more on past growth.

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 misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is only a point-in-time measure. How cyclical is Prosperous Industrial (Holdings)? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

Do Prosperous Industrial (Holdings)'s Current Liabilities Skew 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Prosperous Industrial (Holdings) has total assets of US$193m and current liabilities of US$41m. Therefore its current liabilities are equivalent to approximately 21% of its total assets. This is not a high level of current liabilities, which would not boost the ROCE by much.

The Bottom Line On Prosperous Industrial (Holdings)'s ROCE

Prosperous Industrial (Holdings) has a poor ROCE, and there may be better investment prospects out there. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.