To avoid investing in a business that’s in decline, there’s a few financial metrics that can provide early indications of aging. 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. In light of that, from a first glance at ARC Resources (TSE:ARX), we’ve spotted some signs that it could be struggling, so let’s investigate.
What is 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 ARC Resources:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
0.024 = CA$117m ÷ (CA$5.2b – CA$342m) (Based on the trailing twelve months to March 2020).
Therefore, ARC Resources has an ROCE of 2.4%. In absolute terms, that’s a low return and it also under-performs the Oil and Gas industry average of 5.8%.
See our latest analysis for ARC Resources
In the above chart we have a measured ARC Resources’ prior ROCE against its prior performance, but the future is arguably more important. If you’re interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
So How Is ARC Resources’ ROCE Trending?
The trend of ROCE at ARC Resources is showing some signs of weakness. The company used to generate 10% on its capital five years ago but it has since fallen noticeably. On top of that, the business is utilizing 22% less capital within its operations. The combination of lower ROCE and less capital employed can indicate that a business is likely to be facing some competitive headwinds or seeing an erosion to its moat. If these underlying trends continue, we wouldn’t be too optimistic going forward.
What We Can Learn From ARC Resources’ ROCE
To see ARC Resources reducing the capital employed in the business in tandem with diminishing returns, is concerning. Investors haven’t taken kindly to these developments, since the stock has declined 68% from where it was five years ago. Unless these trends revert to a more positive trajectory, we would look elsewhere.
ARC Resources does have some risks though, and we’ve spotted 1 warning sign for ARC Resources that you might be interested in.
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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