When we're researching a company, it's sometimes hard to find the warning signs, but there are some financial metrics that can help spot trouble early. Businesses in decline often have two underlying trends, firstly, a declining return on capital employed (ROCE) and a declining base of capital employed. Basically the company is earning less on its investments and it is also reducing its total assets. And from a first read, things don't look too good at Yuanda China Holdings (HKG:2789), so let's see why.
What is Return On Capital Employed (ROCE)?
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. To calculate this metric for Yuanda China Holdings, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.0033 = CN¥10.0m ÷ (CN¥9.0b - CN¥6.0b) (Based on the trailing twelve months to June 2020).
Thus, Yuanda China Holdings has an ROCE of 0.3%. Ultimately, that's a low return and it under-performs the Building industry average of 12%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Yuanda China Holdings' ROCE against it's prior returns. If you'd like to look at how Yuanda China Holdings has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.
What The Trend Of ROCE Can Tell Us
There is reason to be cautious about Yuanda China Holdings, given the returns are trending downwards. About five years ago, returns on capital were 3.6%, however they're now substantially lower than that as we saw above. And on the capital employed front, the business is utilizing roughly the same amount of capital as it was back then. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. So because these trends aren't typically conducive to creating a multi-bagger, we wouldn't hold our breath on Yuanda China Holdings becoming one if things continue as they have.Another thing to note, Yuanda China Holdings has a high ratio of current liabilities to total assets of 66%. This can bring about some risks because the company is basically operating with a rather large reliance on its suppliers or other sorts of short-term creditors. Ideally we'd like to see this reduce as that would mean fewer obligations bearing risks.
Our Take On Yuanda China Holdings' ROCE
In summary, it's unfortunate that Yuanda China Holdings is generating lower returns from the same amount of capital. We expect this has contributed to the stock plummeting 79% during the last five years. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.
One more thing: We've identified 2 warning signs with Yuanda China Holdings (at least 1 which doesn't sit too well with us) , and understanding them 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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