Lechwerke (FRA: LEC) might struggle to allocate capital

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What financial indicators can tell us that a business is maturing or even declining? More often than not we will see a downturn to recover on capital employed (ROCE) and a decrease amount capital employed. This combination can tell you that the business not only invests less, but earns less on what it invests. And from the first reading, things don’t look very good Lechwerke (FRA: LEC), let’s see why.

Understanding Return on Capital Employed (ROCE)

If you’ve never worked with ROCE before, it measures the “return” (profit before tax) that a business generates on capital employed in its business. To calculate this metric for Lechwerke, here is the formula:

Return on capital employed = Profit before interest and taxes (EBIT) ÷ (Total assets – Current liabilities)

0.012 = € 7.4m ÷ (€ 1.7bn – € 1.1bn) (Based on the last twelve months up to June 2021).

Thereby, Lechwerke has a ROCE of 1.2%. In absolute terms, this is low efficiency and it is also below the electric utility industry average of 7.4%.

See our latest review for Lechwerke

DB: LEC Return on capital employed October 6, 2021

Although the past is not representative of the future, it can be useful to know the historical performance of a company, which is why we have this graph above. If you want to look at Lechwerke’s performance in the past in other metrics, you can check out this free graph of past income, income and cash flow.

So what is the Lechwerke ROCE trend?

We are a little worried about the ROCE trends at Lechwerke. Unfortunately, yields have declined significantly over the past five years to reach 1.2% today. Equally concerning is that the amount of capital deployed in the company has decreased by 57% over the same period. When you see both ROCE and capital employed declining, it can often be a sign of a mature, declining business that may be in structural decline. If these underlying trends continue, we wouldn’t be too optimistic about the future.

On the other hand, Lechwerke’s short-term liabilities have increased over the past five years to reach 63% of total assets, effectively distorting ROCE to some extent. If current liabilities hadn’t grown as much as they did, the ROCE might actually be even lower. This means that in reality a fairly significant part of the business is funded by suppliers or short term creditors of the business which can lead to some risk.

Our opinion on Lechwerke’s ROCE

In summary, it is unfortunate that Lechwerke is reducing its capital base and also generating lower returns. The market must be optimistic about the future of the stock because while the underlying trends are not very encouraging, the stock has climbed 116%. Regardless, we don’t feel very comfortable with the fundamentals so we’re avoiding this title for now.

One more thing, we spotted 1 warning sign facing Lechwerke that you might find interesting.

If you want to look for solid businesses with great income, check out this free list of companies with good balance sheets and impressive returns on equity.

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

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