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

If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. 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. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. Having said that, while the ROCE is currently high for Sonata Software (NSE:SONATSOFTW), we aren't jumping out of our chairs because returns are decreasing.

What Is Return On Capital Employed (ROCE)?

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. To calculate this metric for Sonata Software, this is the formula:

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

0.27 = ₹5.9b ÷ (₹48b - ₹26b) (Based on the trailing twelve months to September 2023).

Thus, Sonata Software has an ROCE of 27%. That's a fantastic return and not only that, it outpaces the average of 15% earned by companies in a similar industry.

See our latest analysis for Sonata Software

Above you can see how the current ROCE for Sonata Software 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 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. To be more specific, while the ROCE is still high, it's fallen from 38% where it was five years ago. 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.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 54%, which has impacted the ROCE. Without this increase, it's likely that ROCE would be even lower than 27%. And with current liabilities at these levels, suppliers or short-term creditors are effectively funding a large part of the business, which can introduce some risks.

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 long term investors must be optimistic going forward because the stock has returned a huge 704% to shareholders in the last five years. So should these growth trends continue, we'd be optimistic on the stock going forward.

One more thing to note, we've identified 2 warning signs with Sonata Software and understanding these should be part of your investment process.

If you want to search for more stocks that have been earning high returns, check out this free list of stocks with solid balance sheets that are also earning high returns on equity.

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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.