Test Research (TWSE:3030) May Have Issues Allocating Its Capital

Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. 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. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. Having said that, from a first glance at Test Research (TWSE:3030) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

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

For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. To calculate this metric for Test Research, this is the formula:

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

0.17 = NT$1.4b ÷ (NT$9.9b - NT$1.9b) (Based on the trailing twelve months to March 2024).

Therefore, Test Research has an ROCE of 17%. In absolute terms, that's a satisfactory return, but compared to the Electronic industry average of 7.0% it's much better.

See our latest analysis for Test Research

Historical performance is a great place to start when researching a stock so above you can see the gauge for Test Research's ROCE against it's prior returns. If you want to delve into the historical earnings , check out these free graphs detailing revenue and cash flow performance of Test Research.

What The Trend Of ROCE Can Tell Us

When we looked at the ROCE trend at Test Research, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 17% from 22% five years ago. Given the business is employing more capital while revenue has slipped, this is a bit concerning. 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.

Our Take On Test Research's ROCE

From the above analysis, we find it rather worrisome that returns on capital and sales for Test Research have fallen, meanwhile the business is employing more capital than it was five years ago. The market must be rosy on the stock's future because even though the underlying trends aren't too encouraging, the stock has soared 339%. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.

Test Research does come with some risks though, we found 2 warning signs in our investment analysis, and 1 of those is a bit concerning...

While Test Research isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com