Sonata Software's (NSE:SONATSOFTW) Returns On Capital Not Reflecting Well On The Business

Did you know there are some financial metrics that can provide clues of a potential multi-bagger? Amongst other things, we'll want to see two things; firstly, a growing return on capital employed (ROCE) and secondly, an expansion in the company's amount of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. So while Sonata Software (NSE:SONATSOFTW) has a high ROCE right now, lets see what we can decipher from how returns are changing.

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

Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Analysts use this formula to calculate it for Sonata Software:

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

0.26 = ₹5.7b ÷ (₹44b - ₹22b) (Based on the trailing twelve months to June 2023).

Thus, Sonata Software has an ROCE of 26%. In absolute terms that's a great return and it's even better than the IT industry average of 15%.

See our latest analysis for Sonata Software

In the above chart we have measured Sonata Software's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Sonata Software here for free.

What Can We Tell From Sonata Software's ROCE Trend?

On the surface, the trend of ROCE at Sonata Software doesn't inspire confidence. Historically returns on capital were even higher at 36%, but they have dropped over the last five years. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.

Another thing to note, Sonata Software has a high ratio of current liabilities to total assets of 50%. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.

In Conclusion...

In summary, despite lower returns in the short term, we're encouraged to see that Sonata Software is reinvesting for growth and has higher sales as a result. And the stock has done incredibly well with a 369% return over the last five years, so long term investors are no doubt ecstatic with that result. 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 to note, we've identified 1 warning sign with Sonata Software and understanding this should be part of your investment process.

Sonata Software is not the only stock earning high returns. If you'd like to see more, check out our free list of companies earning high returns on equity with solid fundamentals.

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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.