Xero's (ASX:XRO) Returns On Capital Are Heading Higher

There are a few key trends to look for if we want to identify the next multi-bagger. Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. Speaking of which, we noticed some great changes in Xero's (ASX:XRO) returns on capital, so let's have a look.

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. Analysts use this formula to calculate it for Xero:

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

0.18 = NZ$366m ÷ (NZ$3.9b - NZ$1.9b) (Based on the trailing twelve months to September 2024).

So, Xero has an ROCE of 18%. On its own, that's a standard return, however it's much better than the 11% generated by the Software industry.

Check out our latest analysis for Xero

In the above chart we have measured Xero's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free analyst report for Xero .

The Trend Of ROCE

Investors would be pleased with what's happening at Xero. The numbers show that in the last five years, the returns generated on capital employed have grown considerably to 18%. Basically the business is earning more per dollar of capital invested and in addition to that, 117% more capital is being employed now too. So we're very much inspired by what we're seeing at Xero thanks to its ability to profitably reinvest capital.

For the record though, there was a noticeable increase in the company's current liabilities over the period, so we would attribute some of the ROCE growth to that. The current liabilities has increased to 48% of total assets, so the business is now more funded by the likes of its suppliers or short-term creditors. Given it's pretty high ratio, we'd remind investors that having current liabilities at those levels can bring about some risks in certain businesses.

In Conclusion...

To sum it up, Xero has proven it can reinvest in the business and generate higher returns on that capital employed, which is terrific. Since the stock has returned a staggering 110% to shareholders over the last five years, it looks like investors are recognizing these changes. In light of that, we think it's worth looking further into this stock because if Xero can keep these trends up, it could have a bright future ahead.

On the other side of ROCE, we have to consider valuation. That's why we have a FREE intrinsic value estimation for XRO on our platform that is definitely worth checking out.

While Xero 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.

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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.