Capital Allocation Trends At Warner Music Group (NASDAQ:WMG) Aren't Ideal

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 Warner Music Group (NASDAQ:WMG), the trends above didn't look too great.

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 Warner Music Group:

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

0.031 = US$127m ÷ (US$6.8b - US$2.8b) (Based on the trailing twelve months to March 2021).

Thus, Warner Music Group has an ROCE of 3.1%. In absolute terms, that's a low return and it also under-performs the Entertainment industry average of 12%.

Check out our latest analysis for Warner Music Group

In the above chart we have measured Warner Music Group's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Warner Music Group.

So How Is Warner Music Group's ROCE Trending?

In terms of Warner Music Group's historical ROCE movements, the trend doesn't inspire confidence. About five years ago, returns on capital were 4.9%, however they're now substantially lower than that as we saw above. On top of that, it's worth noting that the amount of capital employed within the business has remained relatively steady. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. So because these trends aren't typically conducive to creating a multi-bagger, we wouldn't hold our breath on Warner Music Group becoming one if things continue as they have.

On a separate but related note, it's important to know that Warner Music Group has a current liabilities to total assets ratio of 41%, which we'd consider pretty high. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. Ideally we'd like to see this reduce as that would mean fewer obligations bearing risks.

The Bottom Line On Warner Music Group's ROCE

In summary, it's unfortunate that Warner Music Group is generating lower returns from the same amount of capital. However the stock has delivered a 13% return to shareholders over the last year, so investors might be expecting the trends to turn around. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.

One more thing, we've spotted 1 warning sign facing Warner Music Group that you might find interesting.

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