BAC2684

FINANCIAL STATEMENT
ANALYSIS
Trimester 3 2022
Chapter 8
Return of Invested Capital &
Profitability Analysis
 Return on
Invested Capital

Important of Components of Analyzing Return Analyzing Return

Return on Return on on Net Operating on Common
Invested Capital Invested Capital Assets Equity
- Managerial - Defining invested - Disaggregating - Disaggregating
effectiveness Capital return on net ROCE
- Profitability - Analytical operating asset - Computing
- Planning & control adjustment - Profit margin & return
- Computing asset turnover - Financial
return - Profit margin leverage
analysis - Assessing equity
- Asset turnover growth
analysis
 IMPORTANCE OF RETURN ON INVESTED CAPITAL
 Financial statement analysis involves assessing both risk and return.
 Return on invested capital refers to the company’s earnings relative to both level and
source of financing.
 It measures a company’s success in using financing to generate profits.
 Company’s performance can be analyzed in several ways:
 Revenue, net income and asset growth are performance measures in common use. None
of these measure individually are useful as a comprehensive measure of company
performance.
 The reason is due to Interdependency of business activities
 Analysis of company performance demands joint analysis, where we assess one measure
relatively to another – Increase in revenue v increase in profit?, Asset increase v
Additional sales?, Net income v company’s invested capital.
 IMPORTANCE OF RETURN ON INVESTED CAPITAL
 The relation between income and invested capital is referred to as Return on invested capital
(ROIC) or Return on Investment (ROI) which is probably the most widely recognized measure
of company performance.
 It allows to compare companies' success with invested capital. It also allow us to assess company’s
return relatives to capital investment risk, and we can compare the return on invested capital to
returns of alternative investments.
 Government treasury bonds reflect minimum return due to low risk. Riskier investments expected
to yield higher returns.
 Analysis of ROIC compares company’s income or other performance measure to company’s level
& source of financing.
 ROIC determines company’s ability to succeed, attract financing, repay creditors, & reward
owners.
 Return on invested capital can be used in several areas of analysis including: (1) Managerial
Effectiveness, (2) Level of Profitability, (3) Planning & Control.
 IMPORTANCE OF RETURN ON INVESTED CAPITAL
Measuring Managerial effectiveness
 Level of ROIC depends primarily on skill, resourcefulness, ingenuity & motivation of
management.
 Management is responsible for company’s business activities. It makes financing, investing &
operating decisions. It select actions, plans strategies & executes plans.
 ROIC is relevant measure of company’s managerial effectiveness.
Measuring profitability
 ROIC – an indicator of company’s long-term financial strength. It uses key summary measures
both from the income statement (profits) and SOFP (financing) to assess profitablity.
 This profitability measure has several advantages over other long-term measures of financial
strength or solvency that rely only on SOFP items (such debt-to-equity ratio).
 It effectively convey ROIC from varying perspectives of different financing contributors (creditors
& shareholders).
 IMPORTANCE OF RETURN ON INVESTED CAPITAL
Measure for Planning & Control
 ROIC serves important role in planning, budgeting, coordinating, evaluating, and controlling
business activities.
 This return is composed of returns (and losses) achieved by company’s segments or divisions.
 These segment returns are also made up of return achieved by individual product lines, projects,
and other components.
 Well managed company exercises control over returns achieved by profits centre & rewards its
managers on results.
 In evaluating investing alternatives, management assess performance relative to expected returns
and from this assessment come strategic decision & action plans for company.
 COMPONENTS OF RETURN ON INVESTED CAPITAL

Return on invested capital is computed as: Income

Invested Capital
Defining Invested Capital
 No universal measure of invested capital to compute rate of return.
 No complete agreement on the computation of either the numerator or denominator in
this relationship.

 Different measures of invested capital reflect user’s different perspectives of financial

statement users.

 There are two (2) different measures of invested capital:

 Net operating Assets
 Common Equity Capital
 COMPONENTS OF RETURN ON INVESTED CAPITAL

Net Operating Assets

 Analyst seggregate balance sheet & income statement into operating & non-operating
components and compute return on net operating assets (RNOA) as summary measure of
performance.
 Operating activities are core activities of company – include activities to bring company’s
product or services to market & service customer’s needs and must execute them well over
long run if they are to survive. It has the most impact on stock price.
 In income statement, operating activities include sales, cost of goods sold, selling & general and
administrative (SG & A) expenses.
 On balance sheet, operating activities represented by assets & liabilities relating to income
statement accounts – account receivable, inventories, PPE, accounts payable & accrued
expenses.
 Many firms invest excess cash in financial assets such as marketable securities & earn returns
included in income statement as “other” income.
 Firms also borrow money on short-term & long-term debt, resulting in interest expense.
 COMPONENTS OF RETURN ON INVESTED CAPITAL
 Although effective management on investment portfolio and borrowing can benefit income,
these nonoperating revenues & expenses are regarded as ancillary (support) to core operating
activities of business.
 Thus, investment returns & borrowing expenses do not have major impact on company value,
unless they are extreme.
 The approach is to analyze company along this operating/nonoperating dimension, with return
on net operating assets (RNOA) as measure of performance.
 RNOA is defined as net operating income after tax (NOPAT) divided by average net operating
assets (NOA)
NOPAT
Average NOA
 COMPONENTS OF RETURN ON INVESTED CAPITAL
 More specifically, Operating assets consist of total assets less financial assets
(investment in marketable securities).

 Operating liabilities consist of total liabilities less interest-bearing debt.

 Operating assets less operating liabilities yield Net Operating Assets (NOA)

 The appropriate income measure to compare net operating assets is net

operating income after tax (NOPAT)

 NOPAT = revenues less operating expenses such as COGS, SG & A expenses and
taxes (NOPAT excludes investment income & interest expense).
 COMPONENTS OF RETURN ON INVESTED CAPITAL
net income less preferred dividends
Common Equity Capital average common equity

 Return on common equity (ROCE) is defined as net income less preferred dividends
divided by average common equity
 Common equity = total shareholders’ equity less preferred stock
 Preferred stock is excluded from computation since preferred stock has fixed claim
to net assets and cash flow, like debt.
 Common equity alternatively be defined to total assets less debt & preferred stock.
 The proportion of debt & equity financing of assets is a capital structure decisions
made by a company.
 The amount of equity in capital structure and amount of equity used in
computation of return on equity is a function of degree to which company is
financed by debt (more debt mean less equity).
 COMPONENTS OF RETURN ON INVESTED CAPITAL
Common Equity Capital
 Likewise the net income (numerator) is impacted by amount of interest expense the
company must pay its debt.
 Return on common equity captures both the returns on net operating assets and the
effect of financial leverage (use of debt versus equity in the capital structure)

 Usually computed using average capital available

to a company for the period
 Average used to reflect changes in invested capital
Computing Invested Capital during the period
 Common method is adding beginning and ending
invested capital amounts and divide by 2
 More accurate computation is to average interim
amounts - adding quarter-end invested capital
amount divided by 4
 COMPONENTS OF RETURN ON INVESTED CAPITAL
Adjustments to Invested Capital and Income Numbers

 The analysis of return on invested capital uses reported financial statement numbers.
 Many accounting numbers require analytical adjustment.
 Some numbers not reported in financial statements need to be included.
 Such adjustments are necessary for effective analysis of return on invested capital (like
relating to inventory) as It affect both the numerator and the denominator.
 COMPONENTS OF RETURN ON INVESTED CAPITAL
Return on Net Operating Assets - RNOA
NOPAT Where
• NOPAT = Operating income x (1- tax rate)
(Beginning NOA + Ending NOA) / 2 • NOA = net operating assets

 Denominator of equation, net operating assets (NOA) = operating assets less operating liabilities
 Operating assets & liabilities are those necessary to conduct business – cash, account receivable,
inventories, prepaid expenses, deferred tax assets, PPE, and long-term investments related to startegic
acquisitions (such as equity method investments, goodwill, and long-term investment related to strategic
acquisitions – such as equity method investments, goodwill and acquired intangible assets.
 Netted from operating assets are current operating liabilities – accounts payable & accrued expenses, and
long-term operating liabilities – pensions & other postretirement (OPEB) liabilities & deferred income
tax liabilities
 Nonoperating assets include investment in marketable securities, non-strategic equity investments, and
investments in discontinued operations prior to sale.
 Nonoperating liabilities includes bonds and other long-term interest-bearing liabilities and noncurrent
portion of capitalized leases.
 COMPONENTS OF RETURN ON INVESTED CAPITAL
 Net financial obligation (NFO) equal to nonoperating liabilities less nonoperating assets
(liabilities are listed first to yield a positive sign since most companies have more
financial liabilities than financial assets)
Distinction between Operating and non-operating activities
BALANCE SHEET
Operating assets .................. OA Financial liabilities*.................. FL
Less operating liabilities ..... (OL) Less financial assets ............ (FA)
Net operating assets.......... NOA Net financial obligations..... NFO
Stockholders’ equity+............. SE
Net financing ............ NFO + SE**

Accounting equation : Assets = Liabilities + Equity .We can also represent the
balance sheet with the following operating-based and non-operating based identity:
Net operating assets (NOA) = Net financial obligation (NFO) + Stockholders’ equity (SE)
*Includes preferred stock
+Excludes preferred stock
**NOA = NFO + SE
COMPONENTS OF RETURN ON INVESTED CAPITAL
Distinction between Operating and non-operating activities

NOA = Total assets less nonoperating assets (Short-term & long term investment in
marketable securities)
Operating liabilities = total liabilities less nonoperating liabilities (notes payable to banks,
long-term indebtness payable within 1 year & long-term indebtness
 COMPONENTS OF RETURN ON INVESTED CAPITAL
NOA for Years 8 and 9 is computed as follows:
 Investment in unconsolidated subsidiaries relate to
equity method investment presumed to be strategic
investments treated as operating assets.
 Goodwill is treated as operating so long as
investment is strategic in nature.
 Investment in discontinued operations (not present in
this example) are treated as nonoperating since
business unit no longer contributes to operating
profits

 NFO = financial obligation (notes & other debt

payable & dividends payable (not present in this
example) less financial assets (short-term & long-
term investment in marketable securities.
 COMPONENTS OF RETURN ON INVESTED CAPITAL

Finally,
NOA = NFO + SE

 The numerator of RNOA = net operating profit after tax (NOPAT) is the after-tax profit earned from
net operating assets. Distinction between operating and nonoperating activities is summarised in
typical income statement.
 Operating income includes sales less COGS, operating expenses
(SG & A) and income taxes.
 Operating tax expense has two (2) components;
- Tax provision less tax shield.
- Tax shield on interest refers to reduction of taxable income
arising from deductability of interest expense.

- Tax shield on interest reduces effective tax rate (tax

expense/pretax income) applied to both pretax operating profit &
non-operating revenue & expense.
 COMPONENTS OF RETURN ON INVESTED CAPITAL
 Items exclude from NOPAT include interest revenue & expense, dividend revenue, nonoperating investment
gains and losses, and income or loss from discontinued operations (all computed net of tax).
 Specifically, NOPAT is computed as follows;
NOPAT = (Sales – Operating expenses) x (1 – Tax expense/Pretax profit)
 COMPONENTS OF RETURN ON INVESTED CAPITAL
Return on Common Equity - ROCE
Net income - Preferred dividends Where
Equity is stockholder’s equity
(Beginning equity + Ending equity) / 2 less preferred stock

 ROCE excludes from invested capital all but common shareholders’ equity .
 ROCE for Excell Corporation for year 9 is computed as:

 ROCE consists of two (2) components;

- Operating return (RNOA)
- Nonoperating return [+ or (-) effects of financial
leverage]

 Excell’s higher return on common shareholders’ equity (ROCE) of

14.46% as compared to return on net operating assets (RNOA)of
9.95% reflects favorable effects of financial leverage.
 ANALYZING RETURN ON NET OPERATING ASSETS
 Return on invested capital is useful in management evaluation, profitability analysis, and planning &
control.
 This because the return on invested capital measure includes components with potential to contribute to
an understanding of company performance.

Disaggregating RNOA RNOA =

 Disaggregate this return into meaningful components relative to sales.

Return on net operating assets = Net Operating Profit margin x Net Operating Asset turnover

 The NOPAT-to-sales relation is called net operating profit margin (NOPAT margin)
 Net operating Profit margin: measures operating profitability relative to sales (NOPAT to sales
relation or NOPAT margin)
 Sales-to-NOA is called the net operating asset turnover (NOA turnover)
 Net operating Asset turnover (utilization): measures effectiveness in generating sales from
operating assets (Sales-to-NOA relation or NOA turnover)
 ANALYZING RETURN ON NET OPERATING ASSETS
Disaggregating RNOA
Return on net operating assets = Net Operating Profit margin x Net Operating Asset turnover

 Highlights the role of these components (NOPAT margin & NOA turnover) in determining
return on net operating assets (RNOA)
 NOPAT margin and NOA turnover are useful measures requires analysis to gain insights into
company’s profitability.
 We can describe the major components determining return on net operating assets in the following
exhibit:
 First Level – focus on the interaction of NOPAT margin and NOA turnover.
 Second Level – highlights the other factors determining profit margin and asset turnover.
 ANALYZING RETURN ON NET OPERATING ASSETS
Exhibit below describes the major components determining return on net operating assets.
• First level is on the interaction of NOPAT margin and NOA turnover.
• Second level highlights other important factors determining profit margin and asset turnover.
 ANALYZING RETURN ON NET OPERATING ASSETS

Effect of operating leverage on RNOA

 Net operating assets (NOA) are reduced by increases in operating liabilities, thus increasing net
operating asset turnover. Provided increase in operating liabilities does not effect NOPAT, RNOA
also increased.
 Operating liability effect is seen in alternative decomposition of RNOA;

Where
OA = Operating assets (gross)
OLLEV = Operating liabilities leverage ratio (Average
operating liabilities/Average NOA)
 Since OLLEV is a positive number, increasing OLLEV increases RNOA
 ANALYZING RETURN ON NET OPERATING ASSETS
Effect of operating leverage on RNOA

Intuition behind the equation is that:

- Operating liabilities generally do not entail a cost if used judiciously.
- Example; Increasing accounts payable by delaying payment allows Co. to use suppliers’ capital
that is at low or no cost so long as payment is not delayed too much (supplier, realizing that use
of its capital is adding to its cost [i.e receivables, a non earning asset are higher] will exact a
higher price for its goods or services or may decide not to sell to company altogether.
- Result is a reduction in NOA, no increase in NOPAT, an increase in RNOA
- Firms in effect profited from use of suppliers’ capital and this avoid the needs to finance
operating assets with costly debt or equity capital.
 ANALYZING RETURN ON NET OPERATING ASSETS
Relation between Profit Margin and Asset Turnover
Company X Y Z

RNOA = NOPAT margin (%) x NOA turnover

 Co. X achieves 10% RNOA with relatively high NOPAT margin and low NOA turnover.
 Co. Z achieves same RNOA but low NOPAT margin & high NOA turnover.
 Co.’s Y margin and turnover is between two companies, 10% RNOA with NOPAT margin ½
of Co. X and NOA turnover double of Co. X
 Indicates that many combinations of profit margins and asset turnovers yielding 10% RNOA
 ANALYZING RETURN ON NET OPERATING ASSETS
Relation between Profit Margin and Asset Turnover
RNOA = NOPAT margin (%) x NOA turnover
 RNOA is a function of both margin & turnover, and to analyse a company’s ability to increase
RNOA by increasing profit margin & hold turnover constant or vice versa is not that simple
because the two measures are not independent.
 Profit margin is a function of sales (selling price x units sold) and operating expenses.
 Turnover is also a function of sales (sales/assets)
 Increasing profit margin by increasing selling prices impacts units sold.
 Reductions of marketing-related operating expenses in effort to increase profitability impacts
product demand.
 Selling prices, marketing, R & D, productions & host of other business areas must all be
managed effectively to maximise RNOA
 ANALYZING RETURN ON NET OPERATING ASSETS
Disaggregating Profit Margin

 Operating profit margin is a function of per-unit selling price of product or service compared with
per-unit costs of bringing product or service to market and servicing customer needs after sale.
 Useful to disaggregate pre-tax profit margin (PM) into components;

Pre-tax PM = Pre-tax sales PM + Pre-tax other PM

 ANALYZING RETURN ON NET OPERATING ASSETS
Gross Profit Margin (Gross margin): Measured as revenues less cost of sales.
- Reported as percentage (gross profit percentage), computed as gross profit divided by
sales.
- Key performance measure. All other costs must be covered by gross profit, and any
income earned is the balance remaining after costs.
- Must be sufficiently large to finance essential future-directed discretionary expenditure
(R & D, marketing & advertising)
- Analysing changes in sales & cost of sales is useful in identifying major drivers of gross
profit. Changes in gross profit is often derived from one of the combination of the
following:
Increase (decrease) in sales volume
Increase (decrease) in unit selling price
Increase (decrease) in cost per unit
 ANALYZING RETURN ON NET OPERATING ASSETS
Selling expenses: Relation between selling expenses and revenues varies across industries and
companies.
- Selling expenses in certain companies are primarily commissions that are highly variable,
while others are largely fixed.
- Our analysis is to distinguish between these variable & fixed components which can be
usefully analysed relative to revenues.
- When selling expenses as percentage of revenue show an increase, focus attention on the
increase in selling expense generating the associated increase in revenues.
- Low marginal increase in revenues indicates market saturation, brand loyalty, or increased
expense in new territories.
- Need to distinguish between percentage of selling expense to revenues for new versus
continuing customers. It has implications for forecast of profits.
- If company has to substantially increase selling expenses to increase sales, its profitability is
limited or can decline.
 ANALYZING RETURN ON NET OPERATING ASSETS
General and Administrative Expenses:
• Most G & A expenses are fixed, largely because these expense include salaries & rent.
- Tendency these expenses to increase in prosperous time.
- When analysing these expenses our analysis should direct at both trend in those expense
and percentage of revenue they consume
 ANALYZING RETURN ON NET OPERATING ASSETS
Disaggregation of Asset Turnover
Standard measures of asset turnover in determining return on assets:
Sales
average net operating assets
 Asset turnover measures the intensity with which companies utilize assets
 Most relevant measure of asset utilization is sales,since sales are essential to profits.
 Analysis of turnover must recognize that most assets are committed to future business
activities.
 Turnover rates reflect relative productivity of assets,that is the level of sales volume derive
from each dollar invested in asset.
 Prefer higher turnover rates for assets than lower but this generalization must be viewed with
caution – can increase turnover rates by lowering investment in assets but might be
counterproductive.
 So, investment in assets must be optimized not necessarily minimized
 ANALYZING RETURN ON NET OPERATING ASSETS
Accounts Receivable turnover defined as Sales / Average account receivable
- Reflects how many times receivables are collected on average.
- Receivables are asset that must be financed at some cost of capital. Entail collection risk & require
additional overhead in the form of credit & collection departments.
- Reducing level of receivables lessen costs. If reduce receivables too much with overly restrictive credit
policy, it will adversely impact sales.
- Receivables must therefore be managed effectively.
Average Collection Period is an alternate view of account receivable turnover:
Average collection period = Account receivable / Average daily sales
- Reflects how long accounts receivable are outstanding on average. Lower the receivable turnover rate,
higher the average collection period
 ANALYZING RETURN ON NET OPERATING ASSETS
Inventories turnover computed as Cost of goods sold / Average inventory.
- Ratio uses cost of good sold (COGS) as measure of sales volume because denominator, inventory is
reported at cost, not retail. Both numerator & denominator are measured at cost.
- Decline in inventory turnover ratio indicates firm’s product are uncompetitive.

- Inventories must be financed at some cost and yield additional costs in the form of insurance, storage,
logistics, theft, etc.
- Company's want enough inventory to meet customer demand without stock-outs.

Average inventory days outstanding alternate view to inventory turnover rate

- Average
Indicates theinventory
length of days
time outstanding = Inventory
inventories are / Average
available for sale. daily COGS
- Average inventory days outstanding should be as short as possible. Accomplished by minimizing raw
materials and work in progress inventory through production management techniques such as “just in
time” and use of efficient production processes. Finished good inventory can be minimized by
producing to order and not on estimated demand.
- These management tools increase inventory turnover and reduce the inventory days outstanding.
 ANALYZING RETURN ON NET OPERATING ASSETS
Long-term Operating Asset turnover is computed as
= Sales / Average long-term operating assets
- Capital intensive industries such as manufacturing companies requires large investments in long-term
assets.
- Long-term operating assets must be financed at some cost of capital and must be insured and
maintained.
- Since investment is finite resource, every dollar invested in long-term operating assets is one dollar less
that can be invested in other more quickly turning earning assets.
- Companies desires to minimize investment in long-term operating assets required to generate a dollar
sales.
- Long-term operating assets turnover can be increased by either increasing numerator by increasing
throughput sales or reducing denominator.
- Reducing long-term operating assets is difficult process, besides outright disposal of underutilized
assets, many companies attempt to reduce investment in long-term operating assets by acquiring them
together with other companies (corporate alliances, joint-venture and Special purpose entities (SPE).
 ANALYZING RETURN ON NET OPERATING ASSETS
Accounts Payable turnover is computed as = Cost of goods sold / Average accounts payable
- Reflects how quickly accounts payable are paid, on average.
- Current operating assets like inventories are financed in large part by accounts payable.
- Such payables usually represent interest-free financing & less expensive than using borrowed fund to
finance inventory purchases or production. This is called leaning on trade.
- Payables are reported at cost, not retail prices. For consistency with denominator, cost of goods sold
(not sales) is used in numerator.
- Companies prefer to utilize this cheap source of financing, therefore have lower accounts payable
turnover rate (higher level of payables)
- Lowering accounts payable turnover rate is achieved by delaying payment to suppliers, but this can
damage relationship with supplier if used excessively.
 ANALYZING RETURN ON NET OPERATING ASSETS
Accounts Payable days outstanding is a metric analogous to accounts payable turnover =
Accounts payable / Average daily cost of goods sold
- Lower accounts payable turnover rate correspond to higher average payable days outstanding.
Net Operating Working Capital Turnover = Net Sales/Average net operating working capital
- Net Operating working capital equal to operating current asset less operating current liabilities.
- Net operating working capital is an asset that must be financed just like any other asset.
- So, companies desire to optimize investment in these asset to achieve a higher net operating working capital
turnover rate than a lower one.
- Higher operating working capital turnover reflects less investment in working capital for each dollar of
sales.
- Net operating working capital turns more quickly as receivables and inventories turn more quickly, and it
also turns more quickly when companies lean on trade. (when payables turn more slowly).
- Turnover of net operating working capital improves as a result of proper management of its components.
 ANALYZING RETURN ON NET OPERATING ASSETS
Disaggregation of Asset Turnover
Summary of ratios covered:
 ANALYZING RETURN ON COMMON EQUITY
Return on common shareholders’ equity (ROCE) or return on common equity is of great
interest to shareholders’ of companies.
- Creditors receive fixed return on financing. Preferred shareholders receive fixed dividend, but
common shareholders are provided no fixed or promised returns
- Common shareholders have claims on residual earnings of company only after all other
financing sources are paid.
- Thus, the return on common shareholders’ equity is very important to common shareholders,
- The relationship between return on shareholders’ equity and return on net operating assets is
also important as it bears on the analysis of company’s success with financial leverage.
- Return on common shareholders’ equity serves a key role in equity valuation
 ANALYZING RETURN ON COMMON EQUITY
Disaggregating ROCE
 Disaggregating the return on common equity into components is extremely useful for analysis purpose.
 Return on common shareholders’ equity is computed as;

 We disaggregate return on common shareholders ‘ equity to obtain;

 Where RNOA is return on net operating assets and (LEV x Spread) is the effect of financial leverage. Spread
is the function of interest rate on debt and investment returns
 First component of financial leverage effect is the degree of financial leverage (LEV), measured by relative
amount of net financial obligations & stockholders’ equity used by company to finance net operating assets.
 ANALYZING RETURN ON COMMON EQUITY
Disaggregating ROCE
 Second components is spread, the return on net operating assets (RNOA) less net financial return (NFR),
where NFR is the average net return on financial (non-operating) liabilities and assets.
 NFR is computed as net financial expense (NFE) divided by average net financial obligations (NFO)
outstanding during the year.
 NFO includes interest-bearing liabilities less marketable securities and other non-operating assets
(discontinued operations & non strategic investments)
 NFE includes interest expense less investment returns on marketable securities.
 NFO can either be positive (reflecting more non-operating liabilities than non-operating assets) or
negative (reflecting more non-operating assets than non-operating liabilities)
 NFE can be positive (more interest expense than investment returns) or negative (more investment returns
than interest expense)
ANALYZING RETURN ON COMMON EQUITY
Disaggregating ROCE
 ANALYZING RETURN ON COMMON EQUITY
Leverage and ROCE
Leverage refers to the extent of invested capital from other than common shareholders
- If suppliers of capital (other than common shareholders) receive less than ROA, then common
shareholders benefit; the reverse occurs when suppliers of capital receive more than ROA
- Larger the difference in returns between common equity and other capital suppliers, more
successful (or unsuccessful) is trading on equity
- The effect of financial leverage (LEV) on ROE are summarized as follows;
- Financial leverage increases ROE so long as spread is positive. If Co. can earn higher return
on net operating assets than cost of debt that finances those assets, excess return accrues to
benefit its shareholders.
- Shareholders would better off continuing to employ lower-cost debt as company expands than
to finance expansion with higher-cost equity capital
 ANALYZING RETURN ON COMMON EQUITY
Leverage and ROCE
- Return on common equity (ROCE) consists of both operating components (RNOA) and non-
operating component (LEV x Spread)
- Distinction between operating & non-operating is important for several reasons;
 Majority of companies provide goods & services to customers as primary business and want to
excel their core competencies, not to have poor operating performance masked by good
financial performance.
 Operating activities have most pronounce & long-lasting effects on company value. Stock price
multiple on operating earnings is many times that on financial earnings
 Company can realize an increase in ROE through judicious use of financial leverage, debt
payments (interest & principal) are contractual obligations & must be met in good or bad times.
Increasing debt increases risk of default should cash flows decline, and default can have
disastrous consequences for company, including bankruptcy.
 ANALYZING RETURN ON COMMON EQUITY
Leverage and ROCE
For Excel Corporation, the components of ROCE disaggregated for Year 9 follows:

RNOA = 9.95% ( Slide 20)

LEV ( Average NFO/ Average SE) = (501,680+420,212)/2 / 668,305 + 772,454/2 (slide19)

= 0.64

NFR (NFE/Average NFO = 20,843 x (1- 0.36) / (501,680 + 420,212/2 = 2.90%

Spread (RNOA – NFR = 7.05% = (9.95%-2.90%)

ROCE (RNOA + (LEV x Spread) = 14.46% = 9.95% + (0.64 x 7.05%)

Example – Computing Return on Invested Capital
• This example is based on data extracted from Campbell Soup
Example – Computing Return on Invested Capital
• This example is based on data extracted from Campbell Soup
Example – Computing Return on Invested Capital
• This example is based on data extracted from Campbell Soup
Example – Computing Return on Invested Capital
• This example is based on data extracted from Campbell Soup
Return on Net Operating Assets (RNOA)
• Since the accounting equation stipulates that Assets = Liabilities + Equity, we can also represent the
balance sheet with the following operating-based and non-operating based identity:
• Net Operating Assets (NOA) = Net Financial Obligation (NFO)+Stockholder’s Equity

Year Net Operating Assets Net Financial Obligations Stockholders’ equity

NOA (NFO) (SE)
Year 11 2,872.40 = 1,079.0 + 1,793.40
Year 10 2,709.70 = 1,019.90 + 1,691.80
• Campbell’s soup’s Net Operating Profit After Tax (NOPAT) is computed as follows
Effective tax rate = 39.8% = 265.90/667.40
NOPAT = (6,204.10 – 4,095.50 – 956.20 – 306.70 – 56.30 – 0.8 – 26.2 + 2.40) x (1- 39.80)
= 460.40
• Campbell Soup’s Return On Net Operating Assets (RNOA) for Year 11 is
= 460.40 / (2,872.40 + 2,709.70)/2 = 16.50%
Disaggregated Return on Net Operating Assets

• We can disaggregate Campbell’s Year 11 return on net operating assets (RNOA) into its operating margin
and net operating asset turnover components:

• Return on net operating assets = Operating profit margin x Net operating asset turnover.
= NOPAT x Sales

Sales Average Net Operating Assets.

= 460.40 x 6,204.10

6,204.10 (2,872.40 + 2,709.70) / 2

= 7.42 x 2.22

= 16.5 %
Return on Common Equity
• Campbell’s Soup return on common shareholders’ equity for Year 11 is computed as follows:
• Net Income – Preferred Dividend 401.50 - 0
ROCE = = = 23%
• Average common Equity (1,793.40 + 1,691.80)/2

Disaggregate Return on Common Equity

• Campbell’s Soup’s RNOA is further disaggregated into its margin and turnover component:

RNOA = 16.5%
LEV 0.6% = [(1,079.0 + 1,017.90)] / [(1,793.40 + 1,691.80 /2]
NFR 5.6% = (460.40 – 401.50) / [(1,079.0 + 1,017.9)] / 2
SPREAD 10.6% = 16.5% - 5.6%
ROCE 23 % = 16.5% + (0.60 X 10.9%)
 ANALYZING RETURN ON COMMON EQUITY
Assessing Equity Growth
 We can assess common equity growth rate through earnings retention.
 This analysis emphasizes equity growth without resorting to external financing.
 To assess equity growth, we assume earnings retention and constant dividend payout. The equity growth
rate is computed as:

401.5 – 0 – 142.2
Example:
Campbell Soap
(1,793.4 + 1,619.8)/2

= 14.9%

 This measure implies that Campbell Soup can growth 14.9% per year without increasing current level of
financing & assuming continuation of current level profitability and common stock dividends.
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