Hubei Yihua Chemical Industry (SZSE:000422) Could Be Struggling To Allocate Capital

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look 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. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. Although, when we looked at Hubei Yihua Chemical Industry (SZSE:000422), it didn't seem to tick all of these boxes.

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. To calculate this metric for Hubei Yihua Chemical Industry, this is the formula:

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

0.05 = CN¥661m ÷ (CN¥22b - CN¥9.2b) (Based on the trailing twelve months to March 2024).

Thus, Hubei Yihua Chemical Industry has an ROCE of 5.0%. On its own that's a low return on capital but it's in line with the industry's average returns of 5.5%.

Check out our latest analysis for Hubei Yihua Chemical Industry

Above you can see how the current ROCE for Hubei Yihua Chemical Industry compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free analyst report for Hubei Yihua Chemical Industry .

What The Trend Of ROCE Can Tell Us

Unfortunately, the trend isn't great with ROCE falling from 30% five years ago, while capital employed has grown 167%. However, some of the increase in capital employed could be attributed to the recent capital raising that's been completed prior to their latest reporting period, so keep that in mind when looking at the ROCE decrease. It's unlikely that all of the funds raised have been put to work yet, so as a consequence Hubei Yihua Chemical Industry might not have received a full period of earnings contribution from it.

On a related note, Hubei Yihua Chemical Industry has decreased its current liabilities to 41% of total assets. That could partly explain why the ROCE has dropped. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money. Either way, they're still at a pretty high level, so we'd like to see them fall further if possible.

What We Can Learn From Hubei Yihua Chemical Industry's ROCE

In summary, we're somewhat concerned by Hubei Yihua Chemical Industry's diminishing returns on increasing amounts of capital. The market must be rosy on the stock's future because even though the underlying trends aren't too encouraging, the stock has soared 335%. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.

One more thing: We've identified 5 warning signs with Hubei Yihua Chemical Industry (at least 1 which is concerning) , and understanding these would certainly be useful.

While Hubei Yihua Chemical Industry 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com