Capital Allocation Trends At China First Heavy Industries (SHSE:601106) Aren't Ideal

If you're looking for a multi-bagger, there's a few things to keep an eye out for. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. However, after briefly looking over the numbers, we don't think China First Heavy Industries (SHSE:601106) has the makings of a multi-bagger going forward, but let's have a look at why that may be.

What Is Return On Capital Employed (ROCE)?

For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. The formula for this calculation on China First Heavy Industries is:

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

0.016 = CN¥390m ÷ (CN¥45b - CN¥21b) (Based on the trailing twelve months to September 2023).

So, China First Heavy Industries has an ROCE of 1.6%. In absolute terms, that's a low return and it also under-performs the Machinery industry average of 6.0%.

Check out our latest analysis for China First Heavy Industries

Above you can see how the current ROCE for China First Heavy Industries compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering China First Heavy Industries for free.

How Are Returns Trending?

On the surface, the trend of ROCE at China First Heavy Industries doesn't inspire confidence. To be more specific, ROCE has fallen from 5.6% over the last five years. And considering revenue has dropped while employing more capital, we'd be cautious. If this were to continue, you might be looking at a company that is trying to reinvest for growth but is actually losing market share since sales haven't increased.

On a separate but related note, it's important to know that China First Heavy Industries has a current liabilities to total assets ratio of 46%, which we'd consider pretty high. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.

What We Can Learn From China First Heavy Industries' ROCE

We're a bit apprehensive about China First Heavy Industries because despite more capital being deployed in the business, returns on that capital and sales have both fallen. Long term shareholders who've owned the stock over the last five years have experienced a 30% depreciation in their investment, so it appears the market might not like these trends either. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.

Since virtually every company faces some risks, it's worth knowing what they are, and we've spotted 3 warning signs for China First Heavy Industries (of which 1 is significant!) that you should know about.

While China First Heavy Industries isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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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.