Reverse Engineering Return on Equity

Discover Why RNOA (Return on Net Operating Assets) Is a Better Way to Analyze Than ROE (Return on Equity)

Everybody uses ratios to analyze the performance of a company. This includes the CEO’s or the Chief Executive Officers, the CFO’s or the Chief Financial Officers, the financial managers, accountants, and even the market analysts, security experts and investors on the outside. These ratios are calculated and analyzed to understand how effective and healthy the business is, and also to find out whether the management is doing a good job or not. Ratios are effective ways a lot of information can be arranged and analyzed properly.

There are all kinds of ratios that are used, but perhaps the most popular among them is the ROE or the Return on Equity. There’s however another one that is increasing gaining popularity, and this is the RNOA or the Return on Net Operating Assets. The fact is, more and more investors, analysts and businesses are now using the RNOA to arrange the data and do the analysis. It is believed that RNOA gives the more proper picture of the business, and its relation with the competitors.

Let us now take a closer look at both ROE and RNOA to understand why RNOA might be a better model.

ROE Explained

What is ROE? As mentioned above, ROE is the Return on Equity. Explained in simpler terms, it is the ratio of profits after taxation calculated over the invested equity. To the stockholder, ROE is an indication how effective the business has been for the equity or the stock held. Here’s how ROE is calculated.

ROE = Net Income/Average common equity

ROE has further been broken down according to the DuPont principle of 1919, and this is how it looks.

ROE = Net Income/Common Equity = Net Income/Net Sales x Net Sales/Common Equity

ROE however may not be accurate because it is not able to separate the financial and the operating changes. For instance, let us assume that the ROA or the Return on Assets declined for the business. When this happens, the analyst may conclude that the business is not doing too well, whereas the ROE actually increased because of using leverage.

RNOA Explained

RNOA or the Return on Net Operating Assets is probably the better way to understand business performance. That’s because RNOA is able to separate the operating and financial decisions.

Here’s how RNOA is calculated.

RNOA = After Tax Operating Income/NOA or the Net Operating Assets

This ratio analysis is able to isolate NOA, and because of this, the conclusions arrived at, are always accurate.