Sheela Foam (NSE:SFL) Is Reinvesting At Lower Rates Of Return

What are the early trends we should look for to identify a stock that could multiply in value over the long term? In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. In light of that, when we looked at Sheela Foam (NSE:SFL) and its ROCE trend, we weren't exactly thrilled.

Return On Capital Employed (ROCE): What Is It?

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)

0.13 = ₹2.5b ÷ (₹24b - ₹5.3b) (Based on the trailing twelve months to September 2022).

So, Sheela Foam has an ROCE of 13%. That's a pretty standard return and it's in line with the industry average of 13%.

See our latest analysis for Sheela Foam

Above you can see how the current ROCE for Sheela Foam compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Sheela Foam here for free.

How Are Returns Trending?

On the surface, the trend of ROCE at Sheela Foam doesn't inspire confidence. Around five years ago the returns on capital were 27%, but since then they've fallen to 13%. Meanwhile, the business is utilizing more capital but this hasn't moved the needle much in terms of sales in the past 12 months, so this could reflect longer term investments. 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 21% of total assets. So we could link some of this to the decrease in ROCE. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. 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.

Our Take On 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 47% over the last five 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.

On a separate note, we've found 1 warning sign for Sheela Foam you'll probably want to know about.

While Sheela Foam 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.