Here's What's Concerning About Zhejiang Huada New Materials' (SHSE:605158) Returns On Capital

There are a few key trends to look for if we want to identify the next multi-bagger. Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. In light of that, when we looked at Zhejiang Huada New Materials (SHSE:605158) and its ROCE trend, we weren't exactly thrilled.

Understanding 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 Zhejiang Huada New Materials:

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

0.12 = CN¥306m ÷ (CN¥6.9b - CN¥4.4b) (Based on the trailing twelve months to June 2024).

So, Zhejiang Huada New Materials has an ROCE of 12%. In absolute terms, that's a satisfactory return, but compared to the Metals and Mining industry average of 6.9% it's much better.

Check out our latest analysis for Zhejiang Huada New Materials

While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you'd like to look at how Zhejiang Huada New Materials has performed in the past in other metrics, you can view this free graph of Zhejiang Huada New Materials' past earnings, revenue and cash flow.

So How Is Zhejiang Huada New Materials' ROCE Trending?

When we looked at the ROCE trend at Zhejiang Huada New Materials, we didn't gain much confidence. Around five years ago the returns on capital were 22%, but since then they've fallen to 12%. However it looks like Zhejiang Huada New Materials might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. It may take some time before the company starts to see any change in earnings from these investments.

On a side note, Zhejiang Huada New Materials' current liabilities have increased over the last five years to 63% of total assets, effectively distorting the ROCE to some degree. Without this increase, it's likely that ROCE would be even lower than 12%. 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

Bringing it all together, while we're somewhat encouraged by Zhejiang Huada New Materials' reinvestment in its own business, we're aware that returns are shrinking. Although the market must be expecting these trends to improve because the stock has gained 32% over the last three years. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.

One more thing, we've spotted 1 warning sign facing Zhejiang Huada New Materials that you might find interesting.

While Zhejiang Huada New Materials may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.

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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.