When it comes to investing, there are some useful financial metrics that can warn us when a business is potentially in trouble. When we see a declining return on capital employed (ROCE) in conjunction with a declining base of capital employed, that's often how a mature business shows signs of aging. This reveals that the company isn't compounding shareholder wealth because returns are falling and its net asset base is shrinking. On that note, looking into Ethan Allen Interiors (NYSE:ETH), we weren't too upbeat about how things were going.
Understanding Return On Capital Employed (ROCE)
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 Ethan Allen Interiors, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.11 = US$51m ÷ (US$688m - US$226m) (Based on the trailing twelve months to March 2021).
Thus, Ethan Allen Interiors has an ROCE of 11%. In isolation, that's a pretty standard return but against the Consumer Durables industry average of 14%, it's not as good.
Above you can see how the current ROCE for Ethan Allen Interiors compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Ethan Allen Interiors.
What Does the ROCE Trend For Ethan Allen Interiors Tell Us?
We are a bit worried about the trend of returns on capital at Ethan Allen Interiors. About five years ago, returns on capital were 18%, 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 Ethan Allen Interiors to turn into a multi-bagger.
While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 33%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. Keep an eye on this ratio, because the business could encounter some new risks if this metric gets too high.
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. In spite of that, the stock has delivered a 6.4% return to shareholders who held over the last five years. Either way, we aren't huge fans of the current trends and so with that we think you might find better investments elsewhere.
One more thing to note, we've identified 2 warning signs with Ethan Allen Interiors and understanding them should be part of your investment process.
While Ethan Allen Interiors 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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