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Associated British Foods (LON:ABF) May Have Issues Allocating Its Capital

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Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing 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. Having said that, from a first glance at Associated British Foods (LON:ABF) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

Understanding 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. Analysts use this formula to calculate it for Associated British Foods:

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

0.043 = UK£581m ÷ (UK£16b - UK£2.7b) (Based on the trailing twelve months to February 2021).

So, Associated British Foods has an ROCE of 4.3%. Ultimately, that's a low return and it under-performs the Food industry average of 11%.

Check out our latest analysis for Associated British Foods

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Above you can see how the current ROCE for Associated British Foods compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Associated British Foods here for free.

What The Trend Of ROCE Can Tell Us

When we looked at the ROCE trend at Associated British Foods, we didn't gain much confidence. Around five years ago the returns on capital were 12%, but since then they've fallen to 4.3%. Given the business is employing more capital while revenue has slipped, this is a bit concerning. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.

What We Can Learn From Associated British Foods' ROCE

In summary, we're somewhat concerned by Associated British Foods' diminishing returns on increasing amounts of capital. Investors haven't taken kindly to these developments, since the stock has declined 22% 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.

On a final note, we've found 1 warning sign for Associated British Foods that we think you should be aware of.

While Associated British Foods 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.

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.

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