Returns On Capital At Cato (NYSE:CATO) Paint A Concerning Picture

·3 min read

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. When we see a declining return on capital employed (ROCE) in conjunction with a declining base of capital employed, that's often how a mature business shows signs of aging. This combination can tell you that not only is the company investing less, it's earning less on what it does invest. So after glancing at the trends within Cato (NYSE:CATO), we weren't too hopeful.

Return On Capital Employed (ROCE): What is it?

For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. Analysts use this formula to calculate it for Cato:

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

0.056 = US$22m ÷ (US$591m - US$201m) (Based on the trailing twelve months to July 2021).

Therefore, Cato has an ROCE of 5.6%. Ultimately, that's a low return and it under-performs the Specialty Retail industry average of 18%.

View our latest analysis for Cato

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While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you're interested in investigating Cato's past further, check out this free graph of past earnings, revenue and cash flow.

How Are Returns Trending?

We are a bit anxious about the trends of ROCE at Cato. To be more specific, today's ROCE was 18% five years ago but has since fallen to 5.6%. On top of that, the business is utilizing 21% less capital within its operations. The combination of lower ROCE and less capital employed can indicate that a business is likely to be facing some competitive headwinds or seeing an erosion to its moat. 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.

On a side note, Cato's current liabilities have increased over the last five years to 34% of total assets, effectively distorting the ROCE to some degree. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. While the ratio isn't currently too high, it's worth keeping an eye on this because if it gets particularly high, the business could then face some new elements of risk.

The Bottom Line

To see Cato reducing the capital employed in the business in tandem with diminishing returns, is concerning. It should come as no surprise then that the stock has fallen 24% over the last five years, so it looks like investors are recognizing these changes. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.

One final note, you should learn about the 2 warning signs we've spotted with Cato (including 1 which shouldn't be ignored) .

While Cato isn't earning the highest return, check out this free list of companies that are 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.

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