Some Investors May Be Worried About Traffic Technologies' (ASX:TTI) Returns On Capital

If we're looking to avoid a business that is in decline, what are the trends that can warn us ahead of time? Businesses in decline often have two underlying trends, firstly, a declining return on capital employed (ROCE) and a declining base of capital employed. This reveals that the company isn't compounding shareholder wealth because returns are falling and its net asset base is shrinking. So after we looked into Traffic Technologies (ASX:TTI), 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. To calculate this metric for Traffic Technologies, this is the formula:

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

0.086 = AU$1.5m ÷ (AU$45m - AU$27m) (Based on the trailing twelve months to December 2022).

Therefore, Traffic Technologies has an ROCE of 8.6%. On its own that's a low return, but compared to the average of 5.3% generated by the Infrastructure industry, it's much better.

Check out our latest analysis for Traffic Technologies

Historical performance is a great place to start when researching a stock so above you can see the gauge for Traffic Technologies' ROCE against it's prior returns. If you'd like to look at how Traffic Technologies has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.

SWOT Analysis for Traffic Technologies

What Can We Tell From Traffic Technologies' ROCE Trend?

We are a bit anxious about the trends of ROCE at Traffic Technologies. Unfortunately, returns have declined substantially over the last five years to the 8.6% we see today. What's equally concerning is that the amount of capital deployed in the business has shrunk by 34% over that same period. 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. Typically businesses that exhibit these characteristics aren't the ones that tend to multiply over the long term, because statistically speaking, they've already gone through the growth phase of their life cycle.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 61%, which has impacted the ROCE. Without this increase, it's likely that ROCE would be even lower than 8.6%. 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 On Traffic Technologies' ROCE

In summary, it's unfortunate that Traffic Technologies is shrinking its capital base and also generating lower returns. Investors haven't taken kindly to these developments, since the stock has declined 54% from where it was five years ago. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.

Traffic Technologies does come with some risks though, we found 4 warning signs in our investment analysis, and 2 of those are significant...

While Traffic Technologies isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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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.