Capital Allocation Trends At Solid State (LON:SOLI) Aren't Ideal

If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount 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. Although, when we looked at Solid State (LON:SOLI), it didn't seem to tick all of these boxes.

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. The formula for this calculation on Solid State is:

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

0.12 = UK£4.1m ÷ (UK£55m - UK£21m) (Based on the trailing twelve months to September 2021).

Thus, Solid State has an ROCE of 12%. In absolute terms, that's a satisfactory return, but compared to the Electronic industry average of 9.1% it's much better.

Check out our latest analysis for Solid State

In the above chart we have measured Solid State's 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.

How Are Returns Trending?

When we looked at the ROCE trend at Solid State, we didn't gain much confidence. Around five years ago the returns on capital were 18%, but since then they've fallen to 12%. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 39%, which has impacted the ROCE. Without this increase, it's likely that ROCE would be even lower than 12%. Keep an eye on this ratio, because the business could encounter some new risks if this metric gets too high.

The Bottom Line

To conclude, we've found that Solid State is reinvesting in the business, but returns have been falling. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 168% gain to shareholders who have held over the last five years. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.

One more thing, we've spotted 1 warning sign facing Solid State that you might find interesting.

While Solid State isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.