Some Investors May Be Worried About Tera Software's (NSE:TERASOFT) Returns On Capital

Ignoring the stock price of a company, what are the underlying trends that tell us a business is past the growth phase? A business that's potentially in decline often shows two trends, a return on capital employed (ROCE) that's declining, and a base of capital employed that's also declining. This combination can tell you that not only is the company investing less, it's earning less on what it does invest. Having said that, after a brief look, Tera Software (NSE:TERASOFT) we aren't filled with optimism, but let's investigate further.

Understanding Return On Capital Employed (ROCE)

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. The formula for this calculation on Tera Software is:

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

0.14 = ₹168m ÷ (₹2.1b - ₹876m) (Based on the trailing twelve months to December 2024).

Thus, Tera Software has an ROCE of 14%. That's a relatively normal return on capital, and it's around the 15% generated by the IT industry.

View our latest analysis for Tera Software

While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you'd like to look at how Tera Software has performed in the past in other metrics, you can view this free graph of Tera Software's past earnings, revenue and cash flow.

The Trend Of ROCE

There is reason to be cautious about Tera Software, given the returns are trending downwards. Unfortunately the returns on capital have diminished from the 18% that they were earning five years ago. Meanwhile, capital employed in the business has stayed roughly the flat over the period. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. So because these trends aren't typically conducive to creating a multi-bagger, we wouldn't hold our breath on Tera Software becoming one if things continue as they have.

On a side note, Tera Software has done well to pay down its current liabilities to 41% 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. Keep in mind 41% is still pretty high, so those risks are still somewhat prevalent.

What We Can Learn From Tera Software's ROCE

In summary, it's unfortunate that Tera Software is generating lower returns from the same amount of capital. Yet despite these poor fundamentals, the stock has gained a huge 1,268% over the last five years, so investors appear very optimistic. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.

Tera Software does have some risks though, and we've spotted 1 warning sign for Tera Software that you might be interested in.

While Tera Software isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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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.