When it comes to investing, there are some useful financial metrics that can warn us when a business is potentially in trouble. Businesses in decline often have two underlying trends, firstly, a declining return on capital employed (ROCE) and a declining base of capital employed. Ultimately this means that the company is earning less per dollar invested and on top of that, it's shrinking its base of capital employed. On that note, looking into Linedata Services (EPA:LIN), we weren't too upbeat about how things were going.
Return On Capital Employed (ROCE): What is it?
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. To calculate this metric for Linedata Services, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.13 = €27m ÷ (€296m - €80m) (Based on the trailing twelve months to June 2020).
Thus, Linedata Services has an ROCE of 13%. On its own, that's a standard return, however it's much better than the 7.2% generated by the Software industry.
In the above chart we have measured Linedata Services' 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 Linedata Services here for free.
So How Is Linedata Services' ROCE Trending?
There is reason to be cautious about Linedata Services, given the returns are trending downwards. To be more specific, the ROCE was 17% five years ago, but since then it has dropped noticeably. On top of that, it's worth noting that the amount of capital employed within the business has remained relatively steady. This combination can be indicative of a mature business that still has areas to deploy capital, but the returns received aren't as high due potentially to new competition or smaller margins. So because these trends aren't typically conducive to creating a multi-bagger, we wouldn't hold our breath on Linedata Services becoming one if things continue as they have.
All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. And, the stock has remained flat over the last five years, so investors don't seem too impressed either. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.
Linedata Services does have some risks though, and we've spotted 2 warning signs for Linedata Services 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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This article by Simply Wall St is general in nature. 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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