Capital Allocation Trends At Tera Software (NSE:TERASOFT) Aren't Ideal

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base 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. Although, when we looked at Tera Software (NSE:TERASOFT), it didn't seem to tick all of these boxes.

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 Tera Software, this is the formula:

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

0.087 = ₹97m ÷ (₹2.9b - ₹1.8b) (Based on the trailing twelve months to December 2020).

So, Tera Software has an ROCE of 8.7%. On its own, that's a low figure but it's around the 11% average generated by the IT industry.

See our latest analysis for Tera Software

Historical performance is a great place to start when researching a stock so above you can see the gauge for Tera Software's ROCE against it's prior returns. If you're interested in investigating Tera Software's past further, check out this free graph of past earnings, revenue and cash flow.

How Are Returns Trending?

In terms of Tera Software's historical ROCE movements, the trend isn't fantastic. Around five years ago the returns on capital were 25%, but since then they've fallen to 8.7%. 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.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 62%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. What this means is that in reality, a rather large portion of the business is being funded by the likes of the company's suppliers or short-term creditors, which can bring some risks of its own.

The Bottom Line On Tera Software's ROCE

In summary, we're somewhat concerned by Tera Software's diminishing returns on increasing amounts of capital. In spite of that, the stock has delivered a 21% return to shareholders who held over the last three years. Either way, we aren't huge fans of the current trends and so with that we think you might find better investments elsewhere.

Tera Software does have some risks, we noticed 5 warning signs (and 3 which don't sit too well with us) we think you should know about.

If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.

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