Centrica (LON:CNA) Has Some Difficulty Using Its Capital Effectively

By
Simply Wall St
Published
May 08, 2022
LSE:CNA
Source: Shutterstock

What financial metrics can indicate to us that a company is maturing or even in decline? A business that's potentially in decline often shows two trends, a return on capital employed (ROCE) that's declining, and a base of capital employed that's also declining. 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 Centrica (LON:CNA), we weren't too upbeat about how things were going.

Understanding Return On Capital Employed (ROCE)

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. To calculate this metric for Centrica, this is the formula:

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

0.027 = UK£244m ÷ (UK£27b - UK£18b) (Based on the trailing twelve months to December 2021).

So, Centrica has an ROCE of 2.7%. Ultimately, that's a low return and it under-performs the Integrated Utilities industry average of 5.1%.

Check out our latest analysis for Centrica

roce
LSE:CNA Return on Capital Employed May 8th 2022

In the above chart we have measured Centrica'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 Centrica.

What The Trend Of ROCE Can Tell Us

We are a bit anxious about the trends of ROCE at Centrica. To be more specific, today's ROCE was 9.5% five years ago but has since fallen to 2.7%. On top of that, the business is utilizing 35% less capital within its operations. The combination of lower ROCE and less capital employed can indicate that a business is likely to be facing some competitive headwinds or seeing an erosion to its moat. If these underlying trends continue, we wouldn't be too optimistic going forward.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 66%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. And with current liabilities at these levels, suppliers or short-term creditors are effectively funding a large part of the business, which can introduce some risks.

The Bottom Line

To see Centrica reducing the capital employed in the business in tandem with diminishing returns, is concerning. Investors haven't taken kindly to these developments, since the stock has declined 51% from where it was five years ago. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.

On a final note, we found 2 warning signs for Centrica (1 is potentially serious) you should be aware of.

While Centrica 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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