Capital allocation trends at Headlam Group (LON: HEAD) are not ideal

If you look at a mature business that is past the growth stage, what are some of the underlying trends that emerge? Declining businesses often have two underlying trends, first, a return on capital employed (ROCE) and a based capital employed. This tells us that the company is not only shrinking the size of its net assets, but also declining returns. And from the first reading, things don’t look too good Headlam Group (LON: HEAD), let’s see why.

Understanding Return on Capital Employed (ROCE)

For those who don’t know, ROCE is a measure of a company’s annual pre-tax profit (its return), relative to the capital employed in the company. Analysts use this formula to calculate it for Headlam Group:

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

0.059 = UK £ 16m ÷ (UK £ 467m – UK £ 193m) (Based on the last twelve months up to December 2020).

Therefore, Headlam Group has a ROCE of 5.9%. In the end, that’s a low return and it underperforms the industry average of retail distributors by 17%.

Discover our latest analysis for Headlam Group

roce

In the graph above, we measured Headlam Group’s past ROCE against its past performance, but the future is arguably more important. If you’d like to see what analysts are forecasting for the future, you should check out our free report for Headlam Group.

What can we say about Headlam Group’s ROCE trend?

When it comes to Headlam Group’s historic ROCE movements, the trend does not inspire confidence. About five years ago, returns on capital were 15%, but now they are significantly lower than what we saw above. During this time, the capital employed in the company remained roughly stable over the period. Since returns are dropping and the company has the same number of assets employed, this may suggest that it is a mature company that has not seen much growth in the past five years. If these trends continue, we don’t expect Headlam Group to transform into a multi-bagger.

On a separate but related note, it’s important to know that Headlam Group has a current liabilities to total assets ratio of 41%, which we consider quite high. What this actually means is that suppliers (or short-term creditors) fund a large part of the business, so just be aware that this can introduce some elements of risk. Ideally, we would like this to be reduced, as that would mean less risky bonds.

What we can learn from Headlam Group’s ROCE

In summary, it is unfortunate that Headlam Group generates lower returns from the same amount of capital. Investors should expect better things on the horizon, however, as the stock has risen 17% in the past five years. Either way, we’re not big fans of current trends so we think you might find better investments elsewhere.

Headlam Group could negotiate an attractive price in other respects, so you might find our free estimate of intrinsic value on our quite valuable platform.

While Headlam Group does not currently achieve the highest returns, we have compiled a list of companies that currently achieve over 25% return on equity. Check it out free list here.

This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim 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 information. Simply Wall St has no position in any of the stocks mentioned.

Do you have any comments on this article? Concerned about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.


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