When it comes to investing, there are some useful financial metrics that can warn us when a business is potentially in trouble. 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 the company is producing less profit from its investments and its total assets are decreasing. On that note, looking into ALJ Regional Holdings (NASDAQ:ALJJ), we weren't too upbeat about how things were going.
What is Return On Capital Employed (ROCE)?
For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. To calculate this metric for ALJ Regional Holdings, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.0022 = US$282k ÷ (US$190m - US$61m) (Based on the trailing twelve months to September 2020).
Thus, ALJ Regional Holdings has an ROCE of 0.2%. In absolute terms, that's a low return and it also under-performs the IT industry average of 9.8%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for ALJ Regional Holdings' ROCE against it's prior returns. If you want to delve into the historical earnings, revenue and cash flow of ALJ Regional Holdings, check out these free graphs here.
How Are Returns Trending?
The trend of ROCE at ALJ Regional Holdings is showing some signs of weakness. The company used to generate 5.5% on its capital five years ago but it has since fallen noticeably. What's equally concerning is that the amount of capital deployed in the business has shrunk by 25% over that same period. When you see both ROCE and capital employed diminishing, it can often be a sign of a mature and shrinking business that might be in structural decline. If these underlying trends continue, we wouldn't be too optimistic going forward.
While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 32%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. While the ratio isn't currently too high, it's worth keeping an eye on this because if it gets particularly high, the business could then face some new elements of risk.
What We Can Learn From ALJ Regional Holdings' ROCE
In summary, it's unfortunate that ALJ Regional Holdings is shrinking its capital base and also generating lower returns. Investors haven't taken kindly to these developments, since the stock has declined 67% from where it was five years ago. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.
If you'd like to know more about ALJ Regional Holdings, we've spotted 3 warning signs, and 1 of them is a bit unpleasant.
While ALJ Regional Holdings may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.
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