Amiad Water Systems (LON:AFS) May Have Issues Allocating Its 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. Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, 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. Having said that, from a first glance at Amiad Water Systems (LON:AFS) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

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. The formula for this calculation on Amiad Water Systems is:

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

0.051 = US$5.4m ÷ (US$145m - US$39m) (Based on the trailing twelve months to December 2020).

So, Amiad Water Systems has an ROCE of 5.1%. In absolute terms, that's a low return and it also under-performs the Machinery industry average of 8.9%.

View our latest analysis for Amiad Water Systems

In the above chart we have measured Amiad Water Systems' prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

What The Trend Of ROCE Can Tell Us

Unfortunately, the trend isn't great with ROCE falling from 12% five years ago, while capital employed has grown 52%. Usually this isn't ideal, but given Amiad Water Systems conducted a capital raising before their most recent earnings announcement, that would've likely contributed, at least partially, to the increased capital employed figure. Amiad Water Systems probably hasn't received a full year of earnings yet from the new funds it raised, so these figures should be taken with a grain of salt.

On a related note, Amiad Water Systems has decreased its current liabilities to 27% of total assets. So we could link some of this to the decrease in ROCE. 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. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.

The Bottom Line On Amiad Water Systems' ROCE

To conclude, we've found that Amiad Water Systems is reinvesting in the business, but returns have been falling. Although the market must be expecting these trends to improve because the stock has gained 92% over the last five years. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.

One more thing to note, we've identified 1 warning sign with Amiad Water Systems and understanding this should be part of your investment process.

While Amiad Water Systems 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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