Returns At Honghua Group (HKG:196) Are On The Way Up

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. With that in mind, we've noticed some promising trends at Honghua Group (HKG:196) so let's look a bit deeper.

Understanding 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. Analysts use this formula to calculate it for Honghua Group:

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

0.012 = CN¥84m ÷ (CN¥13b - CN¥5.8b) (Based on the trailing twelve months to June 2021).

Thus, Honghua Group has an ROCE of 1.2%. Ultimately, that's a low return and it under-performs the Energy Services industry average of 4.1%.

View our latest analysis for Honghua Group

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're interested in investigating Honghua Group's past further, check out this free graph of past earnings, revenue and cash flow.

What Can We Tell From Honghua Group's ROCE Trend?

Shareholders will be relieved that Honghua Group has broken into profitability. The company was generating losses five years ago, but has managed to turn it around and as we saw earlier is now earning 1.2%, which is always encouraging. Interestingly, the capital employed by the business has remained relatively flat, so these higher returns are either from prior investments paying off or increased efficiencies. That being said, while an increase in efficiency is no doubt appealing, it'd be helpful to know if the company does have any investment plans going forward. After all, a company can only become a long term multi-bagger if it continually reinvests in itself at high rates of return.

On a separate but related note, it's important to know that Honghua Group has a current liabilities to total assets ratio of 46%, which we'd consider pretty high. 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. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.

In Conclusion...

In summary, we're delighted to see that Honghua Group has been able to increase efficiencies and earn higher rates of return on the same amount of capital. And since the stock has dived 76% over the last five years, there may be other factors affecting the company's prospects. Still, it's worth doing some further research to see if the trends will continue into the future.

One more thing to note, we've identified 1 warning sign with Honghua Group and understanding this should be part of your investment process.

While Honghua Group 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.