Xiamen Leading Optics (SHSE:605118) Might Be Having Difficulty Using Its Capital Effectively

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. Although, when we looked at Xiamen Leading Optics (SHSE:605118), it didn't seem to tick all of these boxes.

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

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 Xiamen Leading Optics, this is the formula:

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

0.077 = CN¥113m ÷ (CN¥1.6b - CN¥113m) (Based on the trailing twelve months to September 2023).

Thus, Xiamen Leading Optics has an ROCE of 7.7%. In absolute terms, that's a low return, but it's much better than the Electronic industry average of 5.3%.

Check out our latest analysis for Xiamen Leading Optics

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

So How Is Xiamen Leading Optics' ROCE Trending?

In terms of Xiamen Leading Optics' historical ROCE movements, the trend isn't fantastic. To be more specific, ROCE has fallen from 50% over the last five years. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.

On a related note, Xiamen Leading Optics has decreased its current liabilities to 7.1% 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. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.

The Key Takeaway

Bringing it all together, while we're somewhat encouraged by Xiamen Leading Optics' reinvestment in its own business, we're aware that returns are shrinking. Unsurprisingly, the stock has only gained 20% over the last three years, which potentially indicates that investors are accounting for this going forward. So if you're looking for a multi-bagger, the underlying trends indicate you may have better chances elsewhere.

One more thing: We've identified 3 warning signs with Xiamen Leading Optics (at least 2 which make us uncomfortable) , and understanding these would certainly be useful.

If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive 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.