Hanon Systems (KRX:018880) 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. 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. This reveals that the company isn't compounding shareholder wealth because returns are falling and its net asset base is shrinking. And from a first read, things don't look too good at Hanon Systems (KRX:018880), so let's see why.

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

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 Hanon Systems, this is the formula:

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

0.037 = ₩210b ÷ (₩9.7t - ₩4.0t) (Based on the trailing twelve months to June 2024).

So, Hanon Systems has an ROCE of 3.7%. In absolute terms, that's a low return and it also under-performs the Auto Components industry average of 9.1%.

Check out our latest analysis for Hanon Systems

In the above chart we have measured Hanon Systems' prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Hanon Systems for free.

What Does the ROCE Trend For Hanon Systems Tell Us?

There is reason to be cautious about Hanon Systems, given the returns are trending downwards. About five years ago, returns on capital were 9.1%, however they're now substantially lower than that as we saw above. And on the capital employed front, the business is utilizing roughly the same amount of capital as it was back then. Since returns are falling and the business has the same amount of assets employed, this can suggest it's a mature business that hasn't had much growth in the last five years. If these trends continue, we wouldn't expect Hanon Systems to turn into a multi-bagger.

On a side note, Hanon Systems' current liabilities have increased over the last five years to 41% of total assets, effectively distorting the ROCE to some degree. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. And with current liabilities at these levels, suppliers or short-term creditors are effectively funding a large part of the business, which can introduce some risks.

What We Can Learn From Hanon Systems' ROCE

In summary, it's unfortunate that Hanon Systems is generating lower returns from the same amount of capital. Long term shareholders who've owned the stock over the last five years have experienced a 60% depreciation in their investment, so it appears the market might not like these trends either. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.

On a separate note, we've found 2 warning signs for Hanon Systems you'll probably want to know about.

While Hanon Systems 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.