Financial ratios are used both internally by chief executive officers (CEOs), chief financial officers (CFOs), accountants and financial managers, as well as externally by accountants and security analysts. They can be used to gauge the effectiveness of a management team, or to evaluate the value of the company's stock for purchase or sale. Ratios are generally accepted across many disciplines and provide an efficient way to organize large amounts of information into readable and analyzable output. While return on equity (ROE) has outstanding evaluation and predictive qualities, return on net operating assets (RNOA) complements ROE, filling in the gaps and assisting in the analysis of management's ability to run a company. In this article we'll explain how interpreting the numbers provides an in-depth evaluation of management's success in creating profitability and provides insight into long-term future growth rates. (To learn more, read Keep Your Eyes on The ROE.)

TUTORIAL: Financial Ratios

Return on Equity (ROE)
ROE is one of the most commonly used and recognized ratios to analyze the profitability of a business. To the common stockholder, it is an indication of how effective management has been with shareholders' capital after excluding payments to all other net capital contributors.

To derive and differentiate ROE from return on total equity:

Then to make an accurate measure of the common shareholders measure:

Since ROE is an important indicator of performance, it is necessary to break the ratio into several components to provide an explanation of a firm's ROE. The DuPont model, created in 1919 by an executive at E.I. du Pont de Nemours & Co., breaks ROE into two ratios:

This reveals that ROE equals net profit margin times the equity turnover. The basic premise of the model implies that management has two options to increase its ROE and thus increase value to its shareholders:

  • Increase the company's equity turnover and use equity more efficiently
  • Become more profitable and subsequently increase the company's net profit margin (For further reading, see The Bottom Line on Margins.)

One of the most common ways to increase the efficiency of assets is to leverage them. Breaking down ROE even more reveals:

Flaws in ROE
While the DuPont formula has proved useful for many years, it is flawed in its inability to separate the decisions regarding both operating and financing changes. For example, an analyst noting a decline in return on assets (ROA) might conclude that the company is experiencing lower operating performance when ROE increased through the use of leverage.

Return on Net Operating Assets (RNOA)
RNOA, on the other hand, successfully separates financing and operating decisions and measures their effectiveness.

RNOA = Operating Income (After Tax) / Net Operating Assets (NOA)

By isolating the NOA, no incorrect conclusions can be drawn from the ratio analysis, thus repairing the missing link form the original DuPont model. Isolating the components also means that changing debt levels do not change operating assets (OA), the profit before interest expense, and the RNOA.

ROE = RNOA + (FLEV X Spread)


= Return From Operating Activities + Return From Non-Operating Activities (Financing)

Comparing Companies
The best way to understand RNOA and ROE is to compare historical periods across many companies: For a 34-year period counting back from 2008, the median ROE achieved by all publicly traded U.S. companies was 12.2%. This ROE is driven by RNOA as illustrated in the following median values:

ROE Disaggregation* ROE = RNOA + (FLEV x Spread)
First Quartile (25th percentile) 6.3% 6.0% 0.05 x 0.5%
Median (50th percentile) 12.2% 10.3% 0.40 x 3.3%
Third Quartile (75th percentile 17.6% 15.6% 0.93 x 10.3%
*Numbers in the table are medians (50th percentile) and quartiles (25th or 75th percentile); thus, the equation does not exactly equal ROE.

The data shows that companies in general are financed rather conservatively as expressed with FLEV< 1.0 and have greater portions of equity in their capital structures. On average, companies are rewarded with a positive spread on money borrowed at 3.3% - but this is not always the case, as seen in the lowest 25% of companies. The most important conclusion from the output is that RNOA averages approximately 84% of ROE (10.3% / 12.2%). (To learn more, read Analyze Investments Quickly With Ratios.)

Bottom Line
ROE is a widely used financial ratio used to evaluate management's ability to run a company. Unfortunately, comparing the ratios between two companies or year over year might lead to the wrong conclusion based solely on those results. The DuPont formula does not separate the operating and non-operating performance and it allows the use of leverage to misrepresent the results. (To learn more, see Spot Quality With ROIC.)

Taking the model one step farther by analyzing RNOA provides a much clearer picture of performance by focusing on operational functions. Once ROE is broken down into RNOA, FLEV and Spread, one can make more accurate predictions of long-term future growth rates using the formula's output.

Related Articles
  1. Markets

    ROA And ROE Give Clear Picture Of Corporate Health

    Both measure performance, but sometimes they tell a very different story. This is why they’re best used together.
  2. Budgeting

    Use ROA To Gauge A Company's Profits

    Do you rely too heavily on ROE? Consider using return on assets for a more complete picture.
  3. Markets

    Understanding Economic Value Added

    Discover the simplicity of this important valuation metric. We reveal its underlying ideas and examine each of its components.
  4. Credit & Loans

    Pre-Qualified Vs. Pre-Approved - What's The Difference?

    These terms may sound the same, but they mean very different things for homebuyers.
  5. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  6. Markets

    PEG Ratio Nails Down Value Stocks

    Learn how this simple calculation can help you determine a stock's earnings potential.
  7. Insurance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  8. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  9. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  10. Fundamental Analysis

    Buy Penny Stocks Using the Wisdom of Peter Lynch

    Are penny stocks any better than playing penny slots in Vegas? What if you used the fundamental analysis principles of Peter Lynch to pick penny stocks?
  1. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  2. Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
  3. Can a company's working capital turnover ratio be negative?

    A company's working capital turnover ratio can be negative when a company's current liabilities exceed its current assets. ... Read Full Answer >>
  4. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  5. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  6. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  2. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  3. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  4. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  5. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
  6. Discount Bond

    A bond that is issued for less than its par (or face) value, or a bond currently trading for less than its par value in the ...
Trading Center