While a firm's bottom line (net income or earnings per share) gets a lot of attention from investors, it's important to dig deeper and determine what is driving performance. Profitability analysis commonly focuses on return on equity (ROE) because it summarizes a firm's efficiency in turning shareholders' invested capital into profit. Traditional profitability analysis breaks down ROE into easily observable ratios chosen to show which components of a firm's operations are doing well, and which are not. (To learn more, read Advanced Financial Statement Analysis.)

Unfortunately, the use of numbers easily observed in the income statement and balance sheet does have drawbacks. Because they mix together operating and financing activities, figures such as net income or total assets include effects from both. But to an analyst trying to determine how well a firm is performing, it is often more insightful to look at operating and financing activities separately. This is where the "Penman-Nissim framework" steps in.

"Ratio Analysis and Equity Valuation: From Research to Practice" (2001), a research paper by Stephen Penman and Doron Nissim, discusses a framework for profitability analysis that is designed to help investors dig into a firm's financial statements and divide its core operational performance from financing effects. Not only does this "Penman-Nissim framework" help to provide a richer picture of a firm's results, it can also serve as a useful tool when analyzing profitability trends over time, and when comparing the profitability of one firm against that of its peers. Let's take a look at how to run these calculations and how to use the results to determine a company's fiscal fitness.

Implementing Penman-Nissim Analysis
Before breaking down ROE into component parts, one may want to first rearrange the income statement and balance sheet in such as way as to separate operating and financing activities. On the balance sheet, an operating asset or liability is one that is involved with a firm's production of goods or services, such as inventory or property, plant and equipment (PP&E), while a financial asset or liability is one that is involved with the firm's financing or investing activities, such as debt sold to external investors or investments in marketable securities.

Figure 1 is a guide for separating operating items from financing items on the balance sheet, but it is not meant to be exhaustive. Furthermore, this process is not purely mechanical; it requires an analyst to make judgments regarding which items belong in which bucket.

Let's take a look at an example. Cash on the balance sheet will be aggregate, and it is up to the user to determine what amount is needed for operations, and how much is "excess". If the amount of cash on the balance sheet is negligible, then all of the cash could probably safely be categorized as operating.

Occasionally, firms hold very large cash balances, which are often in excess of what is needed to run their operations. In these cases, it may be appropriate to classify part of this amount as a financing asset.

How much to classify as financing may be estimated by looking at cash/sales or cash/asset levels of other firms in the same industry, and by judging the company's liquidity needs (to pay employees, suppliers, etc.) to gauge necessary operating cash levels.

Figure 2 is a guide for separating operating from financing items on the income statement. Again, this list of possible items is not meant to be exhaustive. At this stage, it is important to keep income and expense classifications (either operating or financing) consistent with the classifications of corresponding assets and liabilities from the rearranged balance sheet. For example, interest expense is associated with a firm's debt (a financing liability), and is classified as financing expense on the rearranged income statement.

Defining Variables
Now that we have the firm's financial statements organized by operations and financing, we can begin analyzing the composition of ROE. First, we must define a few variables based on our reclassifications:

Balance Sheet Calculations
Net Operating Assets (NOA):

Net Operating Assets (NOA) = Operating Assets - Operating Liabilities

Net Financial Obligations (NFO):

Net Financial Obligations (NFO) = Financing Liabilities - Financing Assets

Common Stockholders' Equity (CSE):

Common Stockholders' Equity (CSE) = Total Stockholders' Equity - Preferred Stockholders' Equity

Minority Interest (MI):
The amount of minority interest reported by the firm on its balance sheet. Many firms do not have minority interest, so this component will not always apply.

Putting it All Together
NOA, NFO, CSE and MI form a new version of the balance sheet. Rather than the traditional arrangement based on sources of capital (Assets = Liabilities + Stockholders' Equity + Minority Interest ), we now have a new arrangement based on operating vs. financing activities. Using the factors above:


Income Statement Calculations
Net operating profit after tax (NOPAT) is the firm's income without any effect from financial items:

Net Operating Profit After Tax (NOPAT) = (Operating Revenues - Operating Expenses ) x ( 1 - Tax Rate )

Net financial expense (NFE) is the firm's net payout for financing, net of tax:

Net Financial Expense (NFE) = ( Financing Expenses - Financing Income ) x (1 - Tax Rate )

Financing Cost Calculation
Net borrowing cost (NBC) is the average interest rate the firm is paying on its financing:

Net Borrowing Cost (NBC) = ( NFE + Preferred Dividend Payout ) / ( Average NFO* )

* The average NFO for 2011 would be calculated as the average of the NFO derived from the 2010 balance sheet (i.e. NFO at the beginning of 2011) and the 2011 balance sheet (i.e. NFO at the end of 2011).

Calculating Effects on ROE
With these variables, we can construct ratios to analyze both the operating and the financing effects on ROE. The first variable below (RNOA) shows the return that the firm is getting on its operating assets, while the second (FLEV) and third (SPREAD) relate to the contribution of financing activities:

Return on Net Operating Assets (RNOA) = NOPAT / ( Average NOA )

If the firm has no financial leverage of any kind, then RNOA will equal ROE; however, this is usually not the case, so we use other metrics to show the effect of financing.

Financial Leverage (FLEV) = ( Average NFO ) / (Average CSE)

FLEV shows the level of financial leverage the firm uses.


SPREAD is the rate of return from operating activities minus the rate the firm is paying for financing.

Putting these together we have:


In plain English, this equation shows that the firm's ROE is composed of:

  1. The rate of return it would achieve without the use of financing
  2. An additional amount driven by the firm's ability to get financing at a rate lower than it can generate through its operations

Using the Results
This result is useful because we can now compare the pure operating profitability of one firm against its peers (by comparing RNOAs) and track operating profitability across time. This comparison can be used as an indication of the health of a firm's business (relative to that of its competitors), and how well management is executing the firm's core operations. Of course, the financing components should not be ignored. If we compare a firm's financial leverage (FLEV) and the operating return spread it realizes over financing costs (SPREAD) with those of other similar firms, we may determine how effectively it is using leverage. Ultimately, this tool can show what effect - operating or financing - is driving ROE, and where the risks to profitability may lie. (To learn more, read the Ratio Analysis Tutorial.)

The Bottom Line
ROE is an important metric used to help judge how well a firm is turning shareholders' invested capital into earnings. Breaking ROE down into a series of ratios can be even more telling, as it adds precision to the analysis by showing just how a firm is achieving its overall ROE. The Penman-Nissim framework complements other means of profitability analysis because it gives a clear and accurate picture of a firm's core operating profitability and its use of leverage. (For more, see Profitability Indicator Ratios: Return On Equity.)