Is Dongguang Chemical (HKG:1702) Set To Make A Turnaround?

Ignoring the stock price of a company, what are the underlying trends that tell us a business is past the growth phase? A business that's potentially in decline often shows two trends, a return on capital employed (ROCE) that's declining, and a base of capital employed that's also declining. Ultimately this means that the company is earning less per dollar invested and on top of that, it's shrinking its base of capital employed. On that note, looking into Dongguang Chemical (HKG:1702), we weren't too upbeat about how things were going.

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 Dongguang Chemical, this is the formula:

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

0.14 = CN¥175m ÷ (CN¥1.7b - CN¥537m) (Based on the trailing twelve months to June 2020).

Therefore, Dongguang Chemical has an ROCE of 14%. In absolute terms, that's a satisfactory return, but compared to the Chemicals industry average of 11% it's much better.

Check out our latest analysis for Dongguang Chemical

Historical performance is a great place to start when researching a stock so above you can see the gauge for Dongguang Chemical's ROCE against it's prior returns. If you're interested in investigating Dongguang Chemical's past further, check out this free graph of past earnings, revenue and cash flow.

How Are Returns Trending?

We are a bit worried about the trend of returns on capital at Dongguang Chemical. About five years ago, returns on capital were 24%, however they're now substantially lower than that as we saw above. Meanwhile, capital employed in the business has stayed roughly the flat over the period. 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 Dongguang Chemical becoming one if things continue as they have.

On a side note, Dongguang Chemical has done well to pay down its current liabilities to 31% of total assets. So we could link some of this to the decrease in ROCE. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. 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

In summary, it's unfortunate that Dongguang Chemical is generating lower returns from the same amount of capital. Long term shareholders who've owned the stock over the last three years have experienced a 34% depreciation in their investment, so it appears the market might not like these trends either. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.

If you'd like to know about the risks facing Dongguang Chemical, we've discovered 1 warning sign that you should be aware of.

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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