Returns On Capital At Sheela Foam (NSE:SFL) Paint An Interesting Picture

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. Having said that, while the ROCE is currently high for Sheela Foam (NSE:SFL), we aren't jumping out of our chairs because returns are decreasing.

Understanding Return On Capital Employed (ROCE)

For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. To calculate this metric for Sheela Foam, this is the formula:

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

0.20 = ₹2.8b ÷ (₹18b - ₹4.5b) (Based on the trailing twelve months to December 2020).

Therefore, Sheela Foam has an ROCE of 20%. That's a fantastic return and not only that, it outpaces the average of 11% earned by companies in a similar industry.

See our latest analysis for Sheela Foam

In the above chart we have measured Sheela Foam'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 Sheela Foam.

The Trend Of ROCE

When we looked at the ROCE trend at Sheela Foam, we didn't gain much confidence. To be more specific, while the ROCE is still high, it's fallen from 34% where it was five years ago. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It may take some time before the company starts to see any change in earnings from these investments.

On a related note, Sheela Foam has decreased its current liabilities to 25% 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 Sheela Foam's ROCE

Bringing it all together, while we're somewhat encouraged by Sheela Foam's reinvestment in its own business, we're aware that returns are shrinking. Since the stock has gained an impressive 27% over the last three years, investors must think there's better things to come. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.

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

High returns are a key ingredient to strong performance, so check out our free list ofstocks earning high returns on equity with solid balance sheets.

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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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