Be Wary Of Evrofarma (ATH:EVROF) And Its Returns On Capital

When it comes to investing, there are some useful financial metrics that can warn us when a business is potentially in trouble. More often than not, we'll see a declining return on capital employed (ROCE) and a declining amount of capital employed. This reveals that the company isn't compounding shareholder wealth because returns are falling and its net asset base is shrinking. And from a first read, things don't look too good at Evrofarma (ATH:EVROF), so let's see why.

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 Evrofarma is:

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

0.044 = €1.5m ÷ (€42m - €9.3m) (Based on the trailing twelve months to June 2020).

Therefore, Evrofarma has an ROCE of 4.4%. In absolute terms, that's a low return and it also under-performs the Food industry average of 8.2%.

See our latest analysis for Evrofarma

While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you're interested in investigating Evrofarma's past further, check out this free graph of past earnings, revenue and cash flow.

The Trend Of ROCE

We are a bit worried about the trend of returns on capital at Evrofarma. About five years ago, returns on capital were 9.2%, however they're now substantially lower than that as we saw above. And on the capital employed front, the business is utilizing roughly the same amount of capital as it was back then. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. So because these trends aren't typically conducive to creating a multi-bagger, we wouldn't hold our breath on Evrofarma becoming one if things continue as they have.

On a related note, Evrofarma has decreased its current liabilities to 22% of total assets. That could partly explain why the ROCE has dropped. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.

What We Can Learn From Evrofarma's ROCE

In the end, the trend of lower returns on the same amount of capital isn't typically an indication that we're looking at a growth stock. Yet despite these poor fundamentals, the stock has gained a huge 247% over the last five years, so investors appear very optimistic. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.

On a final note, we found 4 warning signs for Evrofarma (1 doesn't sit too well with us) you should be aware of.

While Evrofarma 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. 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.
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