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If you're looking at a mature business that's past the growth phase, what are some of the underlying trends that pop up? Businesses in decline often have two underlying trends, firstly, a declining return on capital employed (ROCE) and a declining base 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. And from a first read, things don't look too good at Headlam Group (LON:HEAD), so let's see why.
Understanding Return On Capital Employed (ROCE)
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. Analysts use this formula to calculate it for Headlam Group:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.059 = UK£16m ÷ (UK£467m - UK£193m) (Based on the trailing twelve months to December 2020).
Therefore, Headlam Group has an ROCE of 5.9%. Ultimately, that's a low return and it under-performs the Retail Distributors industry average of 17%.
In the above chart we have measured Headlam Group's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Headlam Group.
What Can We Tell From Headlam Group's ROCE Trend?
In terms of Headlam Group's historical ROCE movements, the trend doesn't inspire confidence. About five years ago, returns on capital were 15%, however they're now substantially lower than that as we saw above. Meanwhile, capital employed in the business has stayed roughly the flat over the period. Since returns are falling and the business has the same amount of assets employed, this can suggest it's a mature business that hasn't had much growth in the last five years. If these trends continue, we wouldn't expect Headlam Group to turn into a multi-bagger.
On a separate but related note, it's important to know that Headlam Group has a current liabilities to total assets ratio of 41%, which we'd consider pretty high. 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. Ideally we'd like to see this reduce as that would mean fewer obligations bearing risks.
What We Can Learn From Headlam Group's ROCE
In summary, it's unfortunate that Headlam Group is generating lower returns from the same amount of capital. Investors must expect better things on the horizon though because the stock has risen 17% in the last five years. Either way, we aren't huge fans of the current trends and so with that we think you might find better investments elsewhere.
Headlam Group could be trading at an attractive price in other respects, so you might find our free intrinsic value estimation on our platform quite valuable.
While Headlam Group may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.
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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