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Don’t Buy Weichai Power Co., Ltd. (HKG:2338) Until You Understand Its ROCE

Today we are going to look at Weichai Power Co., Ltd. (HKG:2338) to see whether it might be an attractive investment prospect. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. 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.

How Do You Calculate Return On Capital Employed?

Analysts use this formula to calculate return on capital employed:

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Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

Or for Weichai Power:

0.092 = CN¥12b ÷ (CN¥235b - CN¥103b) (Based on the trailing twelve months to March 2020.)

Therefore, Weichai Power has an ROCE of 9.2%.

See our latest analysis for Weichai Power

Is Weichai Power's ROCE Good?

One way to assess ROCE is to compare similar companies. It appears that Weichai Power's ROCE is fairly close to the Machinery industry average of 9.2%. Separate from how Weichai Power stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.

Our data shows that Weichai Power currently has an ROCE of 9.2%, compared to its ROCE of 5.7% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly. The image below shows how Weichai Power's ROCE compares to its industry, and you can click it to see more detail on its past growth.

SEHK:2338 Past Revenue and Net Income May 14th 2020
SEHK:2338 Past Revenue and Net Income May 14th 2020

It is important to remember that ROCE shows past performance, and is 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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Weichai Power.

Weichai Power's Current Liabilities And Their Impact On 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.

Weichai Power has total assets of CN¥235b and current liabilities of CN¥103b. As a result, its current liabilities are equal to approximately 44% of its total assets. Weichai Power has a medium level of current liabilities, which would boost its ROCE somewhat.

Our Take On Weichai Power's ROCE

Despite this, its ROCE is still mediocre, and you may find more appealing investments elsewhere. You might be able to find a better investment than Weichai Power. 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).

If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

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.