Ashok Leyland (NSE:ASHOKLEY) Could Be Struggling To Allocate Capital

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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. Having said that, from a first glance at Ashok Leyland (NSE:ASHOKLEY) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

Understanding Return On Capital Employed (ROCE)

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. The formula for this calculation on Ashok Leyland is:

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

0.071 = ₹17b ÷ (₹414b - ₹174b) (Based on the trailing twelve months to March 2022).

Thus, Ashok Leyland has an ROCE of 7.1%. In absolute terms, that's a low return and it also under-performs the Machinery industry average of 14%.

See our latest analysis for Ashok Leyland

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 Ashok Leyland's past further, check out this free graph of past earnings, revenue and cash flow.

How Are Returns Trending?

On the surface, the trend of ROCE at Ashok Leyland doesn't inspire confidence. Around five years ago the returns on capital were 18%, but since then they've fallen to 7.1%. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. If these investments prove successful, this can bode very well for long term stock performance.

On a side note, Ashok Leyland's current liabilities are still rather high at 42% of total assets. This can bring about some risks because the company is basically operating with a rather large reliance on its suppliers or other sorts of short-term creditors. Ideally we'd like to see this reduce as that would mean fewer obligations bearing risks.

What We Can Learn From Ashok Leyland's ROCE

Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Ashok Leyland. Furthermore the stock has climbed 55% over the last five years, it would appear that investors are upbeat about the future. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.

One more thing to note, we've identified 3 warning signs with Ashok Leyland and understanding them should be part of your investment process.

While Ashok Leyland 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.