Today we'll evaluate LH Group Limited (HKG:1978) 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 of all, we'll work out how to 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 is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. All else being equal, a better business will have a higher ROCE. 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 LH Group:

0.12 = HK$74m ÷ (HK$876m - HK$265m) (Based on the trailing twelve months to June 2019.)

Therefore, LH Group has an ROCE of 12%.

View our latest analysis for LH Group

Is LH Group's ROCE Good?

One way to assess ROCE is to compare similar companies. Using our data, we find that LH Group's ROCE is meaningfully better than the 5.1% average in the Hospitality industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Separate from LH Group's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

LH Group's current ROCE of 12% is lower than its ROCE in the past, which was 20%, 3 years ago. So investors might consider if it has had issues recently. You can click on the image below to see (in greater detail) how LH Group's past growth compares to other companies.

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. ROCE is, after all, simply a snap shot of a single year. If LH Group is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.

How LH Group's Current Liabilities Impact Its 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.