Today we are going to look at Shanghai Prime Machinery Company Limited (HKG:2345) to see whether it might be an attractive investment prospect. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared 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. 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.
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 Shanghai Prime Machinery:
0.039 = CN¥250m ÷ (CN¥10b - CN¥3.7b) (Based on the trailing twelve months to June 2019.)
Therefore, Shanghai Prime Machinery has an ROCE of 3.9%.
See our latest analysis for Shanghai Prime Machinery
Does Shanghai Prime Machinery Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. We can see Shanghai Prime Machinery's ROCE is meaningfully below the Machinery industry average of 9.6%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Regardless of how Shanghai Prime Machinery stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). It is likely that there are more attractive prospects out there.
You can see in the image below how Shanghai Prime Machinery's ROCE compares to its industry. Click to see more on past growth.
When considering ROCE, bear in mind that it reflects the past and does not necessarily 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 Shanghai Prime Machinery? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect Shanghai Prime Machinery's ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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 counteract this, we check if a company has high current liabilities, relative to its total assets.