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If we're looking to avoid a business that is in decline, what are the trends that can warn us ahead of time? 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. Basically the company is earning less on its investments and it is also reducing its total assets. In light of that, from a first glance at Graham (NYSE:GHM), we've spotted some signs that it could be struggling, so let's investigate.
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. Analysts use this formula to calculate it for Graham:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.014 = US$1.4m ÷ (US$145m - US$46m) (Based on the trailing twelve months to September 2020).
Therefore, Graham has an ROCE of 1.4%. In absolute terms, that's a low return and it also under-performs the Machinery industry average of 10%.
Above you can see how the current ROCE for Graham 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 Graham.
The Trend Of ROCE
We are a bit anxious about the trends of ROCE at Graham. The company used to generate 16% on its capital five years ago but it has since fallen noticeably. What's equally concerning is that the amount of capital deployed in the business has shrunk by 21% over that same period. When you see both ROCE and capital employed diminishing, it can often be a sign of a mature and shrinking business that might be in structural decline. If these underlying trends continue, we wouldn't be too optimistic going forward.
On a side note, Graham's current liabilities have increased over the last five years to 32% of total assets, effectively distorting the ROCE to some degree. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. While the ratio isn't currently too high, it's worth keeping an eye on this because if it gets particularly high, the business could then face some new elements of risk.
The Bottom Line On Graham's ROCE
In summary, it's unfortunate that Graham is shrinking its capital base and also generating lower returns. Investors must expect better things on the horizon though because the stock has risen 13% 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.
One more thing to note, we've identified 1 warning sign with Graham and understanding it should be part of your investment process.
While Graham 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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