Solid State (LON:SOLI) Might Be Having Difficulty Using Its Capital Effectively

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. In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. In light of that, when we looked at Solid State (LON:SOLI) and its ROCE trend, we weren't exactly thrilled.

Return On Capital Employed (ROCE): What is it?

Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Analysts use this formula to calculate it for Solid State:

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%. By itself that's a normal return on capital and it's in line with the industry's average returns of 12%.

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.

What Does the ROCE Trend For Solid State Tell Us?

On the surface, the trend of ROCE at Solid State doesn't inspire 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%. While the ratio isn't currently too high, it's worth keeping an eye on this because if it gets particularly high, the business could then face some new elements of risk.

The Bottom Line On Solid State's ROCE

Bringing it all together, while we're somewhat encouraged by Solid State's reinvestment in its own business, we're aware that returns are shrinking. Yet to long term shareholders the stock has gifted them an incredible 195% return in the last five years, so the market appears to be rosy about its future. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.

Solid State does have some risks though, and we've spotted 1 warning sign for Solid State that you might be interested in.

While Solid State may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.

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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.