Capital Allocation Trends At Nelco (NSE:NELCO) Aren't Ideal

Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. 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. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. So when we looked at Nelco (NSE:NELCO), they do have a high ROCE, but we weren't exactly elated from how returns are trending.

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 Nelco is:

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

0.22 = ₹246m ÷ (₹2.5b - ₹1.3b) (Based on the trailing twelve months to June 2021).

So, Nelco has an ROCE of 22%. In absolute terms that's a great return and it's even better than the Communications industry average of 7.3%.

View our latest analysis for Nelco

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're interested in investigating Nelco's past further, check out this free graph of past earnings, revenue and cash flow.

So How Is Nelco's ROCE Trending?

On the surface, the trend of ROCE at Nelco doesn't inspire confidence. Historically returns on capital were even higher at 55%, but they have dropped over the last five years. However it looks like Nelco might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.

On a side note, Nelco has done well to pay down its current liabilities to 54% of total assets. So we could link some of this to the decrease in ROCE. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE. Keep in mind 54% is still pretty high, so those risks are still somewhat prevalent.

The Bottom Line On Nelco's ROCE

In summary, Nelco is reinvesting funds back into the business for growth but unfortunately it looks like sales haven't increased much just yet. Yet to long term shareholders the stock has gifted them an incredible 427% return in the last five years, so the market appears to be rosy about its future. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.

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

Nelco 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.
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