There Are Reasons To Feel Uneasy About Sumitomo Chemical India's (NSE:SUMICHEM) Returns On Capital

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount 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. In light of that, when we looked at Sumitomo Chemical India (NSE:SUMICHEM) and its ROCE trend, we weren't exactly thrilled.

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

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. The formula for this calculation on Sumitomo Chemical India is:

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

0.14 = ₹3.6b ÷ (₹35b - ₹9.5b) (Based on the trailing twelve months to December 2023).

Therefore, Sumitomo Chemical India has an ROCE of 14%. By itself that's a normal return on capital and it's in line with the industry's average returns of 14%.

See our latest analysis for Sumitomo Chemical India

In the above chart we have measured Sumitomo Chemical India's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free analyst report for Sumitomo Chemical India .

What Can We Tell From Sumitomo Chemical India's ROCE Trend?

In terms of Sumitomo Chemical India's historical ROCE movements, the trend isn't fantastic. Over the last five years, returns on capital have decreased to 14% from 24% five years ago. And considering revenue has dropped while employing more capital, we'd be cautious. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.

On a side note, Sumitomo Chemical India has done well to pay down its current liabilities to 27% 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. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.

The Key Takeaway

From the above analysis, we find it rather worrisome that returns on capital and sales for Sumitomo Chemical India have fallen, meanwhile the business is employing more capital than it was five years ago. Yet despite these concerning fundamentals, the stock has performed strongly with a 37% return over the last three years, so investors appear very optimistic. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.

Like most companies, Sumitomo Chemical India does come with some risks, and we've found 1 warning sign that you should be aware of.

While Sumitomo Chemical India 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.