Petro Rio (BVMF:PRIO3) Could Be Struggling To Allocate Capital

Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. So when we looked at Petro Rio (BVMF:PRIO3), they do have a high ROCE, but we weren't exactly elated from how returns are trending.

Return On Capital Employed (ROCE): What Is It?

For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. To calculate this metric for Petro Rio, this is the formula:

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

0.22 = R$3.4b ÷ (R$16b - R$973m) (Based on the trailing twelve months to June 2022).

Thus, Petro Rio has an ROCE of 22%. In absolute terms that's a great return and it's even better than the Oil and Gas industry average of 15%.

Check out our latest analysis for Petro Rio

In the above chart we have measured Petro Rio's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Petro Rio here for free.

What The Trend Of ROCE Can Tell Us

When we looked at the ROCE trend at Petro Rio, we didn't gain much confidence. Historically returns on capital were even higher at 31%, but they have dropped over the last five years. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.

On a related note, Petro Rio has decreased its current liabilities to 6.0% of total assets. That could partly explain why the ROCE has dropped. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.

What We Can Learn From Petro Rio's ROCE

Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Petro Rio. And the stock has done incredibly well with a 3,057% return over the last five years, so long term investors are no doubt ecstatic with that result. So should these growth trends continue, we'd be optimistic on the stock going forward.

If you want to continue researching Petro Rio, you might be interested to know about the 1 warning sign that our analysis has discovered.

If you want to search for more stocks that have been earning high returns, check out this free list of stocks with solid balance sheets that are also earning high returns on equity.

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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.