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. Trends like this ultimately mean the business is reducing its investments and also earning less on what it has invested. So after glancing at the trends within China Yuchai International (NYSE:CYD), we weren't too hopeful.
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. The formula for this calculation on China Yuchai International is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.072 = CN¥915m ÷ (CN¥24b - CN¥11b) (Based on the trailing twelve months to June 2020).
Thus, China Yuchai International has an ROCE of 7.2%. Ultimately, that's a low return and it under-performs the Machinery industry average of 10%.
In the above chart we have measured China Yuchai International's 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 China Yuchai International here for free.
What The Trend Of ROCE Can Tell Us
There is reason to be cautious about China Yuchai International, 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. And on the capital employed front, the business is utilizing roughly the same amount of capital as it was back then. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. If these trends continue, we wouldn't expect China Yuchai International to turn into a multi-bagger.Another thing to note, China Yuchai International has a high ratio of current liabilities to total assets of 47%. This can bring about some risks because the company is basically operating with a rather large reliance on its suppliers or other sorts of short-term creditors. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.
The Key Takeaway
All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. The market must be rosy on the stock's future because even though the underlying trends aren't too encouraging, the stock has soared 110%. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.
China Yuchai International does have some risks though, and we've spotted 1 warning sign for China Yuchai International that you might be interested in.
While China Yuchai International 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. 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.
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