Returns On Capital Signal Difficult Times Ahead For Compumedics (ASX:CMP)

When it comes to investing, there are some useful financial metrics that can warn us when a business is potentially in trouble. A business that's potentially in decline often shows two trends, a return on capital employed (ROCE) that's declining, and a base of capital employed that's also declining. This indicates to us that the business is not only shrinking the size of its net assets, but its returns are falling as well. So after we looked into Compumedics (ASX:CMP), the trends above didn't look too great.

Understanding 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 Compumedics:

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

0.12 = AU$2.3m ÷ (AU$41m - AU$21m) (Based on the trailing twelve months to December 2023).

So, Compumedics has an ROCE of 12%. On its own, that's a standard return, however it's much better than the 9.3% generated by the Medical Equipment industry.

View our latest analysis for Compumedics

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 Compumedics has performed in the past in other metrics, you can view this free graph of Compumedics' past earnings, revenue and cash flow.

What The Trend Of ROCE Can Tell Us

In terms of Compumedics' historical ROCE trend, it isn't fantastic. Unfortunately, returns have declined substantially over the last five years to the 12% we see today. In addition to that, Compumedics is now employing 21% less capital than it was five years ago. The fact that both are shrinking is an indication that the business is going through some tough times. If these underlying trends continue, we wouldn't be too optimistic going forward.

On a side note, Compumedics' current liabilities have increased over the last five years to 53% 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. What this means is that in reality, a rather large portion of the business is being funded by the likes of the company's suppliers or short-term creditors, which can bring some risks of its own.

The Bottom Line

In summary, it's unfortunate that Compumedics is shrinking its capital base and also generating lower returns. It should come as no surprise then that the stock has fallen 18% over the last five years, so it looks like investors are recognizing these changes. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.

One final note, you should learn about the 4 warning signs we've spotted with Compumedics (including 1 which is potentially serious) .

While Compumedics 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.

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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.