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. One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing amount 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. So on that note, XRF Scientific (ASX:XRF) looks quite promising in regards to its trends of return on capital.
What Is 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 XRF Scientific:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.18 = AU$8.3m ÷ (AU$56m - AU$9.7m) (Based on the trailing twelve months to June 2022).
Therefore, XRF Scientific has an ROCE of 18%. In absolute terms, that's a satisfactory return, but compared to the Machinery industry average of 12% it's much better.
Check out our latest analysis for XRF Scientific
In the above chart we have measured XRF Scientific's 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 XRF Scientific here for free.
What Can We Tell From XRF Scientific's ROCE Trend?
We like the trends that we're seeing from XRF Scientific. The numbers show that in the last five years, the returns generated on capital employed have grown considerably to 18%. The amount of capital employed has increased too, by 42%. This can indicate that there's plenty of opportunities to invest capital internally and at ever higher rates, a combination that's common among multi-baggers.
On a side note, we noticed that the improvement in ROCE appears to be partly fueled by an increase in current liabilities. Essentially the business now has suppliers or short-term creditors funding about 17% of its operations, which isn't ideal. It's worth keeping an eye on this because as the percentage of current liabilities to total assets increases, some aspects of risk also increase.
Our Take On XRF Scientific's ROCE
A company that is growing its returns on capital and can consistently reinvest in itself is a highly sought after trait, and that's what XRF Scientific has. Since the stock has returned a staggering 370% to shareholders over the last five years, it looks like investors are recognizing these changes. So given the stock has proven it has promising trends, it's worth researching the company further to see if these trends are likely to persist.
One more thing to note, we've identified 2 warning signs with XRF Scientific and understanding them should be part of your investment process.
While XRF Scientific 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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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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