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. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. With that in mind, the ROCE of Cerillion (LON:CER) looks great, so lets see what the trend can tell us.
Understanding Return On Capital Employed (ROCE)
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. To calculate this metric for Cerillion, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.22 = UK£4.9m ÷ (UK£35m - UK£13m) (Based on the trailing twelve months to March 2021).
Thus, Cerillion has an ROCE of 22%. That's a fantastic return and not only that, it outpaces the average of 9.2% earned by companies in a similar industry.
In the above chart we have measured Cerillion's 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 Cerillion here for free.
What The Trend Of ROCE Can Tell Us
We like the trends that we're seeing from Cerillion. The numbers show that in the last five years, the returns generated on capital employed have grown considerably to 22%. Basically the business is earning more per dollar of capital invested and in addition to that, 51% more capital is being employed now too. The increasing returns on a growing amount of capital is common amongst multi-baggers and that's why we're impressed.
On a side note, we noticed that the improvement in ROCE appears to be partly fueled by an increase in current liabilities. Essentially the business now has suppliers or short-term creditors funding about 37% of its operations, which isn't ideal. Keep an eye out for future increases because when the ratio of current liabilities to total assets gets particularly high, this can introduce some new risks for the business.
The Bottom Line
A company that is growing its returns on capital and can consistently reinvest in itself is a highly sought after trait, and that's what Cerillion has. Since the stock has returned a staggering 741% to shareholders over the last five years, it looks like investors are recognizing these changes. With that being said, we still think the promising fundamentals mean the company deserves some further due diligence.
One more thing to note, we've identified 2 warning signs with Cerillion and understanding these should be part of your investment process.
If you want to search for more stocks that have been earning high returns, check out this free list of stocks with solid balance sheets that are also earning high returns on equity.
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