Today we are going to look at Yongsheng Advanced Materials Company Limited (HKG:3608) to see whether it might be an attractive investment prospect. 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, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE measures the amount of pre-tax profits a company can generate from the 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?

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 Yongsheng Advanced Materials:

0.035 = CN¥54m ÷ (CN¥1.7b - CN¥133m) (Based on the trailing twelve months to December 2019.)

Therefore, Yongsheng Advanced Materials has an ROCE of 3.5%.

See our latest analysis for Yongsheng Advanced Materials

Does Yongsheng Advanced Materials Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. In this analysis, Yongsheng Advanced Materials's ROCE appears meaningfully below the 8.6% average reported by the Luxury industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Putting aside Yongsheng Advanced Materials's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. There are potentially more appealing investments elsewhere.

We can see that, Yongsheng Advanced Materials currently has an ROCE of 3.5%, less than the 19% it reported 3 years ago. This makes us wonder if the business is facing new challenges. You can see in the image below how Yongsheng Advanced Materials's ROCE compares to its industry. Click to see more on past growth.

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 only a point-in-time measure. How cyclical is Yongsheng Advanced Materials? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

Do Yongsheng Advanced Materials's Current Liabilities Skew 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. 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.

Yongsheng Advanced Materials has current liabilities of CN¥133m and total assets of CN¥1.7b. As a result, its current liabilities are equal to approximately 8.0% of its total assets. With barely any current liabilities, there is minimal impact on Yongsheng Advanced Materials's admittedly low ROCE.

What We Can Learn From Yongsheng Advanced Materials's ROCE

Nonetheless, there may be better places to invest your capital. Of course, you might also be able to find a better stock than Yongsheng Advanced Materials. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.