Returns On Capital Are Showing Encouraging Signs At Xero (ASX:XRO)

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. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. So when we looked at Xero (ASX:XRO) and its trend of ROCE, we really liked what we saw.

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 Xero:

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

0.058 = NZ$141m ÷ (NZ$2.6b - NZ$229m) (Based on the trailing twelve months to September 2023).

So, Xero has an ROCE of 5.8%. In absolute terms, that's a low return and it also under-performs the Software industry average of 11%.

Check out our latest analysis for Xero

Above you can see how the current ROCE for Xero compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

The Trend Of ROCE

Xero has recently broken into profitability so their prior investments seem to be paying off. Shareholders would no doubt be pleased with this because the business was loss-making five years ago but is is now generating 5.8% on its capital. Not only that, but the company is utilizing 189% more capital than before, but that's to be expected from a company trying to break into profitability. We like this trend, because it tells us the company has profitable reinvestment opportunities available to it, and if it continues going forward that can lead to a multi-bagger performance.

Our Take On Xero's ROCE

To the delight of most shareholders, Xero has now broken into profitability. And with the stock having performed exceptionally well over the last five years, these patterns are being accounted for by investors. With that being said, we still think the promising fundamentals mean the company deserves some further due diligence.

While Xero looks impressive, no company is worth an infinite price. The intrinsic value infographic in our free research report helps visualize whether XRO is currently trading for a fair price.

If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive 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.