Edensoft Holdings' (HKG:1147) Returns On Capital Not Reflecting Well On The Business

There are a few key trends to look for if we want to identify the next multi-bagger. One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing amount of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. Although, when we looked at Edensoft Holdings (HKG:1147), it didn't seem to tick all of these boxes.

What is Return On Capital Employed (ROCE)?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. The formula for this calculation on Edensoft Holdings is:

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

0.07 = CN¥14m ÷ (CN¥368m - CN¥173m) (Based on the trailing twelve months to December 2020).

So, Edensoft Holdings has an ROCE of 7.0%. On its own, that's a low figure but it's around the 7.6% average generated by the IT industry.

View our latest analysis for Edensoft Holdings

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'd like to look at how Edensoft 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

On the surface, the trend of ROCE at Edensoft Holdings doesn't inspire confidence. To be more specific, ROCE has fallen from 44% over the last four years. And considering revenue has dropped while employing more capital, we'd be cautious. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.

On a side note, Edensoft Holdings has done well to pay down its current liabilities to 47% 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. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money. Either way, they're still at a pretty high level, so we'd like to see them fall further if possible.

The Bottom Line

We're a bit apprehensive about Edensoft Holdings because despite more capital being deployed in the business, returns on that capital and sales have both fallen. It should come as no surprise then that the stock has fallen 30% over the last year, so it looks like investors are recognizing these changes. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.

Edensoft Holdings does have some risks though, and we've spotted 2 warning signs for Edensoft Holdings that you might be interested in.

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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