Capital Allocation Trends At Changhua Chemical Technology (SZSE:301518) Aren't Ideal

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. Having said that, from a first glance at Changhua Chemical Technology (SZSE:301518) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

Return On Capital Employed (ROCE): What Is It?

For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. To calculate this metric for Changhua Chemical Technology, this is the formula:

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

0.087 = CN¥129m ÷ (CN¥1.7b - CN¥210m) (Based on the trailing twelve months to March 2024).

So, Changhua Chemical Technology has an ROCE of 8.7%. In absolute terms, that's a low return, but it's much better than the Chemicals industry average of 5.5%.

Check out our latest analysis for Changhua Chemical Technology

Historical performance is a great place to start when researching a stock so above you can see the gauge for Changhua Chemical Technology's ROCE against it's prior returns. If you'd like to look at how Changhua Chemical Technology has performed in the past in other metrics, you can view this free graph of Changhua Chemical Technology's past earnings, revenue and cash flow.

The Trend Of ROCE

When we looked at the ROCE trend at Changhua Chemical Technology, we didn't gain much confidence. To be more specific, ROCE has fallen from 31% over the last three years. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. If these investments prove successful, this can bode very well for long term stock performance.

On a related note, Changhua Chemical Technology has decreased its current liabilities to 12% 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.

The Bottom Line On Changhua Chemical Technology's ROCE

In summary, despite lower returns in the short term, we're encouraged to see that Changhua Chemical Technology is reinvesting for growth and has higher sales as a result. And there could be an opportunity here if other metrics look good too, because the stock has declined 49% in the last year. So we think it'd be worthwhile to look further into this stock given the trends look encouraging.

Changhua Chemical Technology does come with some risks though, we found 2 warning signs in our investment analysis, and 1 of those makes us a bit uncomfortable...

While Changhua Chemical Technology 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.