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Today we are going to look at Wonderful Sky Financial Group Holdings Limited (HKG:1260) to see whether it might be an attractive investment prospect. 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. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. 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 Wonderful Sky Financial Group Holdings:

0.14 = HK$108m ÷ (HK$1.9b – HK$479m) (Based on the trailing twelve months to September 2018.)

So, Wonderful Sky Financial Group Holdings has an ROCE of 14%.

View our latest analysis for Wonderful Sky Financial Group Holdings

Does Wonderful Sky Financial Group Holdings Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Wonderful Sky Financial Group Holdings’s ROCE appears to be substantially greater than the 11% average in the Media industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of where Wonderful Sky Financial Group Holdings sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

Wonderful Sky Financial Group Holdings’s current ROCE of 14% is lower than 3 years ago, when the company reported a 21% ROCE. Therefore we wonder if the company is facing new headwinds.

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, after all, simply a snap shot of a single year. How cyclical is Wonderful Sky Financial Group Holdings? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

How Wonderful Sky Financial Group Holdings’s Current Liabilities Impact Its ROCE

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counter this, investors can check if a company has high current liabilities relative to total assets.

Wonderful Sky Financial Group Holdings has total liabilities of HK$479m and total assets of HK$1.9b. Therefore its current liabilities are equivalent to approximately 26% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.

What We Can Learn From Wonderful Sky Financial Group Holdings’s ROCE

This is good to see, and with a sound ROCE, Wonderful Sky Financial Group Holdings could be worth a closer look. You might be able to find a better buy than Wonderful Sky Financial Group Holdings. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

I will like Wonderful Sky Financial Group Holdings better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.