Greaves Cotton (NSE:GREAVESCOT) Is Finding It Tricky To Allocate Its Capital

Ignoring the stock price of a company, what are the underlying trends that tell us a business is past the growth phase? 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. So after we looked into Greaves Cotton (NSE:GREAVESCOT), the trends above didn't look too great.

What is 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. To calculate this metric for Greaves Cotton, this is the formula:

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

0.037 = ₹303m ÷ (₹13b - ₹4.6b) (Based on the trailing twelve months to June 2021).

Thus, Greaves Cotton has an ROCE of 3.7%. Ultimately, that's a low return and it under-performs the Machinery industry average of 14%.

Check out our latest analysis for Greaves Cotton

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'd like to look at how Greaves Cotton has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.

What Can We Tell From Greaves Cotton's ROCE Trend?

There is reason to be cautious about Greaves Cotton, given the returns are trending downwards. About five years ago, returns on capital were 24%, however they're now substantially lower than that as we saw above. On top of that, it's worth noting that the amount of capital employed within the business has remained relatively steady. This combination can be indicative of a mature business that still has areas to deploy capital, but the returns received aren't as high due potentially to new competition or smaller margins. If these trends continue, we wouldn't expect Greaves Cotton to turn into a multi-bagger.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 36%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. Keep an eye on this ratio, because the business could encounter some new risks if this metric gets too high.

What We Can Learn From Greaves Cotton's ROCE

All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. Despite the concerning underlying trends, the stock has actually gained 24% over the last five years, so it might be that the investors are expecting the trends to reverse. Regardless, we don't like the trends as they are and if they persist, we think you might find better investments elsewhere.

One more thing to note, we've identified 1 warning sign with Greaves Cotton and understanding this should be part of your investment process.

While Greaves Cotton 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.
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