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. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. Having said that, from a first glance at Cathay Biotech (SHSE:688065) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.
What Is Return On Capital Employed (ROCE)?
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. Analysts use this formula to calculate it for Cathay Biotech:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.029 = CN¥455m ÷ (CN¥19b - CN¥2.9b) (Based on the trailing twelve months to December 2023).
So, Cathay Biotech has an ROCE of 2.9%. In absolute terms, that's a low return and it also under-performs the Chemicals industry average of 5.6%.
Above you can see how the current ROCE for Cathay Biotech compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Cathay Biotech for free.
The Trend Of ROCE
The trend of ROCE doesn't look fantastic because it's fallen from 16% five years ago, while the business's capital employed increased by 416%. However, some of the increase in capital employed could be attributed to the recent capital raising that's been completed prior to their latest reporting period, so keep that in mind when looking at the ROCE decrease. It's unlikely that all of the funds raised have been put to work yet, so as a consequence Cathay Biotech might not have received a full period of earnings contribution from it.
On a related note, Cathay Biotech has decreased its current liabilities to 15% of total assets. That could partly explain why the ROCE has dropped. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.
The Key Takeaway
In summary, we're somewhat concerned by Cathay Biotech's diminishing returns on increasing amounts of capital. Investors haven't taken kindly to these developments, since the stock has declined 18% from where it was three years ago. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.
If you're still interested in Cathay Biotech it's worth checking out our FREE intrinsic value approximation for 688065 to see if it's trading at an attractive price in other respects.
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.
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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.