We Like These Underlying Return On Capital Trends At Xero (ASX:XRO)

What trends should we look for it we want to identify stocks that can multiply in value over the long term? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. With that in mind, we've noticed some promising trends at Xero (ASX:XRO) so let's look a bit deeper.

Understanding Return On Capital Employed (ROCE)

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. The formula for this calculation on Xero is:

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

0.035 = NZ$82m ÷ (NZ$2.6b - NZ$237m) (Based on the trailing twelve months to September 2022).

So, Xero has an ROCE of 3.5%. Ultimately, that's a low return and it under-performs the Software industry average of 9.3%.

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.

How Are Returns Trending?

Xero has recently broken into profitability so their prior investments seem to be paying off. The company was generating losses five years ago, but now it's earning 3.5% which is a sight for sore eyes. Not only that, but the company is utilizing 953% 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.

In another part of our analysis, we noticed that the company's ratio of current liabilities to total assets decreased to 9.2%, which broadly means the business is relying less on its suppliers or short-term creditors to fund its operations. Therefore we can rest assured that the growth in ROCE is a result of the business' fundamental improvements, rather than a cooking class featuring this company's books.

What We Can Learn From Xero's ROCE

Long story short, we're delighted to see that Xero's reinvestment activities have paid off and the company is now profitable. And a remarkable 142% total return over the last five years tells us that investors are expecting more good things to come in the future. Therefore, we think it would be worth your time to check if these trends are going to continue.

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.

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.