A firm increases value by – 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 6