When it comes to investing, there are some useful financial metrics that can warn us when a business is potentially in trouble. Typically, we'll see the trend of both return on capital employed (ROCE) declining and this usually coincides with a decreasing amount of capital employed. Trends like this ultimately mean the business is reducing its investments and also earning less on what it has invested. So after we looked into China Tobacco International (HK) (HKG:6055), the trends above didn't look too great.
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. Analysts use this formula to calculate it for China Tobacco International (HK):
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.15 = HK$306m ÷ (HK$4.8b - HK$2.7b) (Based on the trailing twelve months to December 2021).
Thus, China Tobacco International (HK) has an ROCE of 15%. In absolute terms, that's a satisfactory return, but compared to the Retail Distributors industry average of 8.9% it's much better.
In the above chart we have measured China Tobacco International (HK)'s prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
What Does the ROCE Trend For China Tobacco International (HK) Tell Us?
There is reason to be cautious about China Tobacco International (HK), given the returns are trending downwards. Unfortunately the returns on capital have diminished from the 20% that they were earning five years ago. On top of that, it's worth noting that the amount of capital employed within the business has remained relatively steady. 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 China Tobacco International (HK) becoming one if things continue as they have.
On a separate but related note, it's important to know that China Tobacco International (HK) has a current liabilities to total assets ratio of 56%, which we'd consider pretty high. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. Ideally we'd like to see this reduce as that would mean fewer obligations bearing risks.
All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. Long term shareholders who've owned the stock over the last year have experienced a 29% 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.
China Tobacco International (HK) does come with some risks though, we found 3 warning signs in our investment analysis, and 1 of those makes us a bit uncomfortable...
While China Tobacco International (HK) isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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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.