When it comes to investing, there are some useful financial metrics that can warn us when a business is potentially in trouble. More often than not, we'll see a declining return on capital employed (ROCE) and a declining amount of capital employed. 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, CEI (SGX:AVV) we aren't filled with optimism, but let's investigate further.
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. To calculate this metric for CEI, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.18 = S$7.8m ÷ (S$70m - S$27m) (Based on the trailing twelve months to June 2020).
So, CEI has an ROCE of 18%. In absolute terms, that's a satisfactory return, but compared to the Electronic industry average of 13% it's much better.
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 CEI has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.
What The Trend Of ROCE Can Tell Us
We are a bit worried about the trend of returns on capital at CEI. About five years ago, returns on capital were 29%, however they're now substantially lower than that as we saw above. 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. If these trends continue, we wouldn't expect CEI to turn into a multi-bagger.
On a related note, CEI has decreased its current liabilities to 39% of total assets. That could partly explain why the ROCE has dropped. 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.
The Bottom Line On CEI's ROCE
In summary, it's unfortunate that CEI is generating lower returns from the same amount of capital. Since the stock has skyrocketed 235% over the last five years, it looks like investors have high expectations of the stock. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.
One more thing: We've identified 5 warning signs with CEI (at least 1 which is significant) , and understanding them would certainly be useful.
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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