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When we're researching a company, it's sometimes hard to find the warning signs, but there are some financial metrics that can help spot trouble early. A business that's potentially in decline often shows two trends, a return on capital employed (ROCE) that's declining, and a base of capital employed that's also declining. This combination can tell you that not only is the company investing less, it's earning less on what it does invest. On that note, looking into Journey Energy (TSE:JOY), we weren't too upbeat about how things were going.
What is 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. To calculate this metric for Journey Energy, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.12 = CA$38m ÷ (CA$362m - CA$55m) (Based on the trailing twelve months to March 2022).
Therefore, Journey Energy has an ROCE of 12%. By itself that's a normal return on capital and it's in line with the industry's average returns of 12%.
In the above chart we have measured Journey Energy's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Journey Energy here for free.
The Trend Of ROCE
The trend of ROCE at Journey Energy is showing some signs of weakness. The company used to generate 17% on its capital five years ago but it has since fallen noticeably. In addition to that, Journey Energy is now employing 26% less capital than it was five years ago. The fact that both are shrinking is an indication that the business is going through some tough times. Typically businesses that exhibit these characteristics aren't the ones that tend to multiply over the long term, because statistically speaking, they've already gone through the growth phase of their life cycle.
The Bottom Line
To see Journey Energy reducing the capital employed in the business in tandem with diminishing returns, is concerning. The market must be rosy on the stock's future because even though the underlying trends aren't too encouraging, the stock has soared 275%. 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 identified 4 warning signs with Journey Energy (at least 1 which doesn't sit too well with us) , and understanding them would certainly be useful.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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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.