North Electro-OpticLtd (SHSE:600184) May Have Issues Allocating Its Capital

Ignoring the stock price of a company, what are the underlying trends that tell us a business is past the growth phase? Typically, we'll see the trend of both return on capital employed (ROCE) declining and this usually coincides with a decreasing amount of capital employed. Trends like this ultimately mean the business is reducing its investments and also earning less on what it has invested. Having said that, after a brief look, North Electro-OpticLtd (SHSE:600184) we aren't filled with optimism, but let's investigate further.

What Is Return On Capital Employed (ROCE)?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for North Electro-OpticLtd:

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

0.0016 = CN¥4.1m ÷ (CN¥4.4b - CN¥1.9b) (Based on the trailing twelve months to June 2024).

Thus, North Electro-OpticLtd has an ROCE of 0.2%. In absolute terms, that's a low return and it also under-performs the Aerospace & Defense industry average of 4.1%.

View our latest analysis for North Electro-OpticLtd

Above you can see how the current ROCE for North Electro-OpticLtd compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free analyst report for North Electro-OpticLtd .

What The Trend Of ROCE Can Tell Us

There is reason to be cautious about North Electro-OpticLtd, given the returns are trending downwards. Unfortunately the returns on capital have diminished from the 1.6% that they were earning five years ago. Meanwhile, capital employed in the business has stayed roughly the flat over the period. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. So because these trends aren't typically conducive to creating a multi-bagger, we wouldn't hold our breath on North Electro-OpticLtd becoming one if things continue as they have.

On a side note, North Electro-OpticLtd's current liabilities have increased over the last five years to 42% of total assets, effectively distorting the ROCE to some degree. Without this increase, it's likely that ROCE would be even lower than 0.2%. And with current liabilities at these levels, suppliers or short-term creditors are effectively funding a large part of the business, which can introduce some risks.

The Key Takeaway

All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. It should come as no surprise then that the stock has fallen 18% over the last five years, so it looks like investors are recognizing these changes. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.

One more thing to note, we've identified 1 warning sign with North Electro-OpticLtd and understanding this should be part of your investment process.

For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.