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. Typically, we'll see the trend of both return on capital employed (ROCE) declining and this usually coincides with a decreasing amount of capital employed. This indicates to us that the business is not only shrinking the size of its net assets, but its returns are falling as well. 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?
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 China Yuchai International, this is the formula:
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).
So, China Yuchai International has an ROCE of 7.2%. In absolute terms, that's a low return and it also under-performs the Machinery industry average of 9.3%.
Above you can see how the current ROCE for China Yuchai International compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free report for China Yuchai International.
So How Is China Yuchai International's ROCE Trending?
There is reason to be cautious about China Yuchai International, given the returns are trending downwards. Unfortunately the returns on capital have diminished from the 11% that they were earning five years ago. 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. 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 effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.
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. Yet despite these concerning fundamentals, the stock has performed strongly with a 97% return over the last five years, so investors appear very optimistic. Regardless, we don't feel to comfortable with the fundamentals so we'd be steering clear of this stock for now.
If you want to continue researching China Yuchai International, you might be interested to know about the 2 warning signs that our analysis has discovered.
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.
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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