What underlying fundamental trends can indicate that a company might be in decline? Businesses in decline often have two underlying trends, firstly, a declining return on capital employed (ROCE) and a declining base of capital employed. This indicates to us that the business is not only shrinking the size of its net assets, but its returns are falling as well. So after we looked into Seiwa Chuo Holdings (TYO:7531), the trends above didn't look too great.
Return On Capital Employed (ROCE): What is it?
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. The formula for this calculation on Seiwa Chuo Holdings is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.011 = JP¥163m ÷ (JP¥27b - JP¥12b) (Based on the trailing twelve months to December 2020).
Thus, Seiwa Chuo Holdings has an ROCE of 1.1%. In absolute terms, that's a low return and it also under-performs the Trade Distributors industry average of 6.3%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Seiwa Chuo Holdings' ROCE against it's prior returns. If you want to delve into the historical earnings, revenue and cash flow of Seiwa Chuo Holdings, check out these free graphs here.
How Are Returns Trending?
We are a bit worried about the trend of returns on capital at Seiwa Chuo Holdings. Unfortunately the returns on capital have diminished from the 6.0% that they were earning five years ago. Meanwhile, capital employed in the business has stayed roughly the flat over the period. This combination can be indicative of a mature business that still has areas to deploy capital, but the returns received aren't as high due potentially to new competition or smaller margins. If these trends continue, we wouldn't expect Seiwa Chuo Holdings to turn into a multi-bagger.
On a related note, Seiwa Chuo Holdings has decreased its current liabilities to 43% 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. 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. Either way, they're still at a pretty high level, so we'd like to see them fall further if possible.
What We Can Learn From Seiwa Chuo Holdings' ROCE
In the end, the trend of lower returns on the same amount of capital isn't typically an indication that we're looking at a growth stock. It should come as no surprise then that the stock has fallen 13% over the last five years, so it looks like investors are recognizing these changes. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.
Seiwa Chuo Holdings does come with some risks though, we found 3 warning signs in our investment analysis, and 1 of those doesn't sit too well with us...
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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