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. Typically, we'll see the trend of both return on capital employed (ROCE) declining and this usually coincides with a decreasing amount of capital employed. Basically the company is earning less on its investments and it is also reducing its total assets. And from a first read, things don't look too good at Gem Diamonds (LON:GEMD), so let's see why.

Understanding Return On Capital Employed (ROCE)

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for Gem Diamonds:

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

0.13 = US$47m ÷ (US$414m – US$61m) (Based on the trailing twelve months to December 2020).

Thus, Gem Diamonds has an ROCE of 13%. In absolute terms, that's a pretty standard return but compared to the Metals and Mining industry average it falls behind.

View our latest analysis for Gem Diamonds

In the above chart we have measured Gem Diamonds' 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 Gem Diamonds here for free.

What Can We Tell From Gem Diamonds' ROCE Trend?

There is reason to be cautious about Gem Diamonds, given the returns are trending downwards. About five years ago, returns on capital were 21%, however they're now substantially lower than that as we saw above. And on the capital employed front, the business is utilizing roughly the same amount of capital as it was back then. This combination can be indicative of a mature business that still has areas to deploy capital, but the returns received aren't as high due potentially to new competition or smaller margins. If these trends continue, we wouldn't expect Gem Diamonds to turn into a multi-bagger.

The Bottom Line

In summary, it's unfortunate that Gem Diamonds is generating lower returns from the same amount of capital. Long term shareholders who've owned the stock over the last five years have experienced a 47% depreciation in their investment, so it appears the market might not like these trends either. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.

If you'd like to know more about Gem Diamonds, we've spotted 2 warning signs, and 1 of them is potentially serious.

While Gem Diamonds 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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