Some Investors May Be Worried About Headlam Group's (LON:HEAD) Returns On Capital

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. However, after investigating Headlam Group (LON:HEAD), we don't think it's current trends fit the mold of a multi-bagger.

What is Return On Capital Employed (ROCE)?

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

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

0.13 = UK£36m ÷ (UK£467m - UK£192m) (Based on the trailing twelve months to June 2021).

So, Headlam Group has an ROCE of 13%. In absolute terms, that's a pretty normal return, and it's somewhat close to the Retail Distributors industry average of 16%.

See 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.

The Trend Of ROCE

On the surface, the trend of ROCE at Headlam Group doesn't inspire confidence. To be more specific, ROCE has fallen from 19% over the last five years. 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.

On a side note, Headlam Group's current liabilities are still rather high at 41% of total assets. 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.

Our Take On Headlam Group'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 Headlam Group. These growth trends haven't led to growth returns though, since the stock has fallen 36% over the last five years. As a result, we'd recommend researching this stock further to uncover what other fundamentals of the business can show us.

One more thing, we've spotted 3 warning signs facing Headlam Group that you might find interesting.

While Headlam Group 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.