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– Growing sales
– Earning high income per dollar of sales
– Keeping the net assets that generate the sales as
low as possible
1
• First level breakdown: Analyze the
components of ROCE
– Return on common equity (ROCE)
– ROCE = Comprehensive income (CI)/CSE
– There are two factors affecting ROCE
• Operating efficiency
• Financial leverage
2
• If a company has leverage (i.e., it has NFO)
– ROCE = RNOA + [FLEV x (RNOA – NBC)]
• RNOA = Return on net operating assets
= operating income/NOA
• FLEV = NFO/CSE
• (RNOA – NBC) = spread (difference between RNOA and
net borrowing cost (NBC))
3
• If a company has no leverage (i.e., it has NFA)
– ROCE = RNOA - [(NFA/CSE) x (RNOA – RNFA)]
• RNOA = Return on net operating assets
= operating income/NOA
• NFA/CSE – reflects the fact that the firm is a net lender,
i.e., it has financial income in addition to operating
income
• (RNOA – RNFA) = spread (difference between RNOA
and the return on net financial assets, RNFA)
– A positive spread means operating activities are more
profitable than financing activities (which is usually the case),
and ROCE will be lower than RNOA
– RNFA = Net financial income/NFA
4
• Second level breakdown: Analyze the
components of RNOA
– The two drivers of RNOA are
• Operating profit margin (PM)
= Operating income (after tax)/Sales
– Shows the profitability of each dollar of sales
• Asset turnover (ATO)
= Sales/NOA
– Measures sales revenue per dollar of NOA
– The inverse, 1/ATO = NOA/Sales, shows the $ amount of NOA
used to generate 1$ of sales. For example, if the ATO = 2,
1/ATO = 0.5, indicating that the firm uses $0.50 of NOA to
generate $1.00 of sales
5
• Third level breakdown: Analyze the
components of PM and ATO
– For PM drivers, analyze the components that
make up operating income
– For ATO drivers, analyze the components of NOA
• A useful ratio in analyzing ATO is operating leverage
(OLLEV)
• OLLEV = Operating liability (OL)/NOA
– Operating liabilities reduce the NOA that are employed, and
increases ATO