Zhongyu Energy Holdings (HKG:3633) Is Finding It Tricky To Allocate Its Capital

When we're researching a company, it's sometimes hard to find the warning signs, but there are some financial metrics that can help spot trouble early. When we see a declining return on capital employed (ROCE) in conjunction with a declining base of capital employed, that's often how a mature business shows signs of aging. Trends like this ultimately mean the business is reducing its investments and also earning less on what it has invested. In light of that, from a first glance at Zhongyu Energy Holdings (HKG:3633), we've spotted some signs that it could be struggling, so let's investigate.

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Return On Capital Employed (ROCE): What Is It?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for Zhongyu Energy Holdings:

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

0.057 = HK$846m ÷ (HK$26b - HK$11b) (Based on the trailing twelve months to June 2024).

Therefore, Zhongyu Energy Holdings has an ROCE of 5.7%. In absolute terms, that's a low return and it also under-performs the Gas Utilities industry average of 8.6%.

See our latest analysis for Zhongyu Energy Holdings

Historical performance is a great place to start when researching a stock so above you can see the gauge for Zhongyu Energy Holdings' ROCE against it's prior returns. If you'd like to look at how Zhongyu Energy Holdings has performed in the past in other metrics, you can view this free graph of Zhongyu Energy Holdings' past earnings, revenue and cash flow.

What Can We Tell From Zhongyu Energy Holdings' ROCE Trend?

There is reason to be cautious about Zhongyu Energy Holdings, given the returns are trending downwards. About five years ago, returns on capital were 11%, however they're now substantially lower than that as we saw above. 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 Zhongyu Energy Holdings becoming one if things continue as they have.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 44%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. What this means is that in reality, a rather large portion of the business is being funded by the likes of the company's suppliers or short-term creditors, which can bring some risks of its own.

What We Can Learn From Zhongyu Energy Holdings' ROCE

In the end, the trend of lower returns on the same amount of capital isn't typically an indication that we're looking at a growth stock. It should come as no surprise then that the stock has fallen 20% over the last five years, so it looks like investors are recognizing these changes. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.

One more thing to note, we've identified 2 warning signs with Zhongyu Energy Holdings and understanding these should be part of your investment process.

While Zhongyu Energy Holdings 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.