Capital Allocation Trends At McKesson Europe (HMSE:CLS1) Aren't Ideal

When it comes to investing, there are some useful financial metrics that can warn us when a business is potentially in trouble. More often than not, we'll see a declining return on capital employed (ROCE) and a declining amount of capital employed. Trends like this ultimately mean the business is reducing its investments and also earning less on what it has invested. And from a first read, things don't look too good at McKesson Europe (HMSE:CLS1), so let's see why.

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. The formula for this calculation on McKesson Europe is:

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

0.027 = €83m ÷ (€7.9b - €4.9b) (Based on the trailing twelve months to March 2020).

So, McKesson Europe has an ROCE of 2.7%. In absolute terms, that's a low return and it also under-performs the Healthcare industry average of 6.9%.

Check out our latest analysis for McKesson Europe

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're interested in investigating McKesson Europe's past further, check out this free graph of past earnings, revenue and cash flow.

How Are Returns Trending?

We are a bit anxious about the trends of ROCE at McKesson Europe. To be more specific, today's ROCE was 8.8% five years ago but has since fallen to 2.7%. What's equally concerning is that the amount of capital deployed in the business has shrunk by 29% 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. If these underlying trends continue, we wouldn't be too optimistic going forward.

On a side note, McKesson Europe's current liabilities have increased over the last five years to 62% 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. And with current liabilities at these levels, suppliers or short-term creditors are effectively funding a large part of the business, which can introduce some risks.

The Key Takeaway

In summary, it's unfortunate that McKesson Europe is shrinking its capital base and also generating lower returns. And long term shareholders have watched their investments stay flat over the last three years. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.

One more thing: We've identified 3 warning signs with McKesson Europe (at least 1 which doesn't sit too well with us) , and understanding these would certainly be useful.

While McKesson Europe 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.
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