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Here's What's Concerning About Simonds Group's (ASX:SIO) Returns On Capital

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Did you know there are some financial metrics that can provide clues of a potential multi-bagger? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing amount 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. So while Simonds Group (ASX:SIO) has a high ROCE right now, lets see what we can decipher from how returns are changing.

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 Simonds Group:

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

0.24 = AU$11m ÷ (AU$174m - AU$127m) (Based on the trailing twelve months to June 2021).

Therefore, Simonds Group has an ROCE of 24%. On its own that's a fantastic return on capital, though it's the same as the Consumer Durables industry average of 24%.

View our latest analysis for Simonds Group

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Historical performance is a great place to start when researching a stock so above you can see the gauge for Simonds Group's ROCE against it's prior returns. If you're interested in investigating Simonds Group's past further, check out this free graph of past earnings, revenue and cash flow.

So How Is Simonds Group's ROCE Trending?

When we looked at the ROCE trend at Simonds Group, we didn't gain much confidence. Historically returns on capital were even higher at 50%, but they have dropped over the last five years. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.

On a related note, Simonds Group has decreased its current liabilities to 73% 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. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money. Keep in mind 73% is still pretty high, so those risks are still somewhat prevalent.

Our Take On Simonds Group's ROCE

Bringing it all together, while we're somewhat encouraged by Simonds Group's reinvestment in its own business, we're aware that returns are shrinking. Unsurprisingly, the stock has only gained 21% over the last five years, which potentially indicates that investors are accounting for this going forward. As a result, if you're hunting for a multi-bagger, we think you'd have more luck elsewhere.

On a final note, we've found 2 warning signs for Simonds Group that we think you should be aware of.

High returns are a key ingredient to strong performance, so check out our free list ofstocks earning high returns on equity with solid balance sheets.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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