Some Investors May Be Worried About Hongcheng Environmental Technology's (HKG:2265) Returns On Capital

If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out 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. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. Having said that, while the ROCE is currently high for Hongcheng Environmental Technology (HKG:2265), we aren't jumping out of our chairs because returns are decreasing.

Understanding Return On Capital Employed (ROCE)

For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. Analysts use this formula to calculate it for Hongcheng Environmental Technology:

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

0.24 = CN¥130m ÷ (CN¥677m - CN¥126m) (Based on the trailing twelve months to June 2022).

So, Hongcheng Environmental Technology has an ROCE of 24%. In absolute terms that's a great return and it's even better than the Commercial Services industry average of 8.2%.

View our latest analysis for Hongcheng Environmental Technology

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 want to delve into the historical earnings, revenue and cash flow of Hongcheng Environmental Technology, check out these free graphs here.

The Trend Of ROCE

In terms of Hongcheng Environmental Technology's historical ROCE movements, the trend isn't fantastic. While it's comforting that the ROCE is high, three years ago it was 36%. 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. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.

On a side note, Hongcheng Environmental Technology has done well to pay down its current liabilities to 19% 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 Bottom Line

In summary, despite lower returns in the short term, we're encouraged to see that Hongcheng Environmental 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 34% in the last year. As a result, we'd recommend researching this stock further to uncover what other fundamentals of the business can show us.

If you want to know some of the risks facing Hongcheng Environmental Technology we've found 2 warning signs (1 is potentially serious!) that you should be aware of before investing here.

Hongcheng Environmental Technology is not the only stock earning high returns. If you'd like to see more, check out our free list of companies earning high returns on equity with solid fundamentals.

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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.