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. Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base 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. However, after investigating Jiangsu Yawei Machine Tool (SZSE:002559), we don't think it's current trends fit the mold of a multi-bagger.

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 Jiangsu Yawei Machine Tool, this is the formula:

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

0.011 = CN¥26m ÷ (CN¥4.7b - CN¥2.3b) (Based on the trailing twelve months to September 2024).

Therefore, Jiangsu Yawei Machine Tool has an ROCE of 1.1%. In absolute terms, that's a low return and it also under-performs the Machinery industry average of 5.2%.

While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you'd like to look at how Jiangsu Yawei Machine Tool has performed in the past in other metrics, you can view this free graph of Jiangsu Yawei Machine Tool's past earnings, revenue and cash flow.

The Trend Of ROCE

In terms of Jiangsu Yawei Machine Tool's historical ROCE movements, the trend isn't fantastic. Around five years ago the returns on capital were 5.2%, but since then they've fallen to 1.1%. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 50%, which has impacted the ROCE. Without this increase, it's likely that ROCE would be even lower than 1.1%. 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.

The Key Takeaway

Bringing it all together, while we're somewhat encouraged by Jiangsu Yawei Machine Tool's reinvestment in its own business, we're aware that returns are shrinking. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 116% gain to shareholders who have held over the last five years. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.

One more thing: We've identified 3 warning signs with Jiangsu Yawei Machine Tool (at least 1 which makes us a bit uncomfortable) , and understanding these would certainly be useful.

For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high 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.