Headlam Group (LON:HEAD) Is Finding It Tricky To Allocate Its Capital

When it comes to investing, there are some useful financial metrics that can warn us when a business is potentially in trouble. Typically, we'll see the trend of both return on capital employed (ROCE) declining and this usually coincides with a decreasing amount of capital employed. This reveals that the company isn't compounding shareholder wealth because returns are falling and its net asset base is shrinking. On that note, looking into Headlam Group (LON:HEAD), we weren't too upbeat about how things were going.

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. Analysts use this formula to calculate it for Headlam Group:

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

0.059 = UK£16m ÷ (UK£467m - UK£193m) (Based on the trailing twelve months to December 2020).

Therefore, Headlam Group has an ROCE of 5.9%. Ultimately, that's a low return and it under-performs the Retail Distributors industry average of 15%.

View our latest analysis for Headlam Group

In the above chart we have measured Headlam Group's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Headlam Group.

What Can We Tell From Headlam Group's ROCE Trend?

We are a bit worried about the trend of returns on capital at Headlam Group. To be more specific, the ROCE was 15% five years ago, but since then it has dropped noticeably. Meanwhile, capital employed in the business has stayed roughly the flat over the period. Since returns are falling and the business has the same amount of assets employed, this can suggest it's a mature business that hasn't had much growth in the last five years. If these trends continue, we wouldn't expect Headlam Group to turn into a multi-bagger.

On a separate but related note, it's important to know that Headlam Group has a current liabilities to total assets ratio of 41%, which we'd consider pretty high. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.

The Key Takeaway

In the end, the trend of lower returns on the same amount of capital isn't typically an indication that we're looking at a growth stock. Despite the concerning underlying trends, the stock has actually gained 22% over the last five years, so it might be that the investors are expecting the trends to reverse. Either way, we aren't huge fans of the current trends and so with that we think you might find better investments elsewhere.

If you're still interested in Headlam Group it's worth checking out our FREE intrinsic value approximation to see if it's trading at an attractive price in other respects.

If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive 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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