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. Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. Speaking of which, we noticed some great changes in Telefonaktiebolaget LM Ericsson's (STO:ERIC B) returns on capital, so let's have a look.
Understanding 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. Analysts use this formula to calculate it for Telefonaktiebolaget LM Ericsson:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.21 = kr33b ÷ (kr281b - kr125b) (Based on the trailing twelve months to June 2021).
So, Telefonaktiebolaget LM Ericsson has an ROCE of 21%. That's a fantastic return and not only that, it outpaces the average of 15% earned by companies in a similar industry.
Above you can see how the current ROCE for Telefonaktiebolaget LM Ericsson 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 Telefonaktiebolaget LM Ericsson here for free.
What The Trend Of ROCE Can Tell Us
Telefonaktiebolaget LM Ericsson is showing promise given that its ROCE is trending up and to the right. More specifically, while the company has kept capital employed relatively flat over the last five years, the ROCE has climbed 43% in that same time. So it's likely that the business is now reaping the full benefits of its past investments, since the capital employed hasn't changed considerably. On that front, things are looking good so it's worth exploring what management has said about growth plans going forward.
On a side note, we noticed that the improvement in ROCE appears to be partly fueled by an increase in current liabilities. Effectively this means that suppliers or short-term creditors are now funding 44% of the business, which is more than it was five years ago. Given it's pretty high ratio, we'd remind investors that having current liabilities at those levels can bring about some risks in certain businesses.
What We Can Learn From Telefonaktiebolaget LM Ericsson's ROCE
In summary, we're delighted to see that Telefonaktiebolaget LM Ericsson has been able to increase efficiencies and earn higher rates of return on the same amount of capital. Since the stock has returned a solid 87% to shareholders over the last five years, it's fair to say investors are beginning to recognize these changes. With that being said, we still think the promising fundamentals mean the company deserves some further due diligence.
Like most companies, Telefonaktiebolaget LM Ericsson does come with some risks, and we've found 2 warning signs that you should be aware of.
Telefonaktiebolaget LM Ericsson 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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