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. One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing amount of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. In light of that, when we looked at Lakshmi Machine Works (NSE:LAXMIMACH) and its ROCE trend, we weren't exactly thrilled.
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. To calculate this metric for Lakshmi Machine Works, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.068 = ₹1.4b ÷ (₹30b - ₹10b) (Based on the trailing twelve months to December 2021).
So, Lakshmi Machine Works has an ROCE of 6.8%. Ultimately, that's a low return and it under-performs the Machinery industry average of 15%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Lakshmi Machine Works' ROCE against it's prior returns. If you want to delve into the historical earnings, revenue and cash flow of Lakshmi Machine Works, check out these free graphs here.
What Does the ROCE Trend For Lakshmi Machine Works Tell Us?
When we looked at the ROCE trend at Lakshmi Machine Works, we didn't gain much confidence. To be more specific, ROCE has fallen from 12% over the last five years. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. If these investments prove successful, this can bode very well for long term stock performance.
The Key Takeaway
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Lakshmi Machine Works. And long term investors must be optimistic going forward because the stock has returned a huge 167% to shareholders in the last five years. So while investors seem to be recognizing these promising trends, we would look further into this stock to make sure the other metrics justify the positive view.
One more thing, we've spotted 1 warning sign facing Lakshmi Machine Works that you might find interesting.
While Lakshmi Machine Works 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.
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.