Here's What's Concerning About Serica Energy's (LON:SQZ) Returns On Capital

What are the early trends we should look for to identify a stock that could multiply in value over the long term? Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing 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 Serica Energy (LON:SQZ) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

Understanding Return On Capital Employed (ROCE)

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. To calculate this metric for Serica Energy, this is the formula:

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

0.0075 = UK£2.5m ÷ (UK£479m - UK£142m) (Based on the trailing twelve months to June 2021).

Therefore, Serica Energy has an ROCE of 0.7%. Ultimately, that's a low return and it under-performs the Oil and Gas industry average of 3.8%.

View our latest analysis for Serica Energy

Above you can see how the current ROCE for Serica Energy compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Serica Energy here for free.

What Does the ROCE Trend For Serica Energy Tell Us?

On the surface, the trend of ROCE at Serica Energy doesn't inspire confidence. Around five years ago the returns on capital were 2.8%, but since then they've fallen to 0.7%. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 30%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. Keep an eye on this ratio, because the business could encounter some new risks if this metric gets too high.

Our Take On Serica Energy'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 Serica Energy. And long term investors must be optimistic going forward because the stock has returned a huge 1,144% to shareholders in the last five years. So while investors seem to be recognizing these promising trends, we would look further into this stock to make sure the other metrics justify the positive view.

On a final note, we found 2 warning signs for Serica Energy (1 is significant) you should be aware of.

While Serica Energy 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.