Return on reverse engineering capital
Find out why RNOA (return on net operating assets) is a better way to analyze than ROE (return on equity)
Everyone uses ratios to analyze the performance of a company. This includes CEOs or CEOs, CFOs or CFOs, CFOs, accountants, and even market analysts, security experts, and outside investors. These ratios are calculated and analyzed to understand how effective and healthy the business is, and also to know if the management is doing a good job or not. Ratios are effective ways to organize and analyze a large amount of information appropriately.
There are all kinds of ratios that are used, but perhaps the most popular among them is ROE or Return on Equity. However, there is another one that is gaining popularity and this is the RNOA or Return on Net Operating Assets. The fact is that more and more investors, analysts and companies are now using RNOA to organize data and perform analysis. RNOA is believed to provide the most appropriate image of the business and its relationship with competitors.
Let’s now take a closer look at both ROE and RNOA to understand why RNOA might be a better model.
What is ROE? As mentioned earlier, ROE is return on equity. Explained in simpler terms, it is the after-tax earnings ratio calculated on invested capital. For the shareholder, ROE is an indication of how effective the business has been for the capital or shares it owns. This is how ROE is calculated.
ROE = Net Income / Average Common Equity
The ROE has further been broken down according to the DuPont principle of 1919, and this is what it looks like.
ROE = Net Income / Common Capital = Net Income / Net Sales x Net Sales / Common Capital
However, ROE may not be exact because it cannot separate financial and operational changes. For example, suppose the ROA or return on assets decreased for the company. When this happens, the analyst may conclude that the business is not doing too well, while the ROE actually increased due to leverage.
RNOA or return on net operating assets is probably the best way to understand business performance. That’s because RNOA can separate operational and financial decisions.
This is how the RNOA is calculated.
RNOA = Operating Income After Tax / NOA or Net Operating Assets
This ratio analysis is capable of isolating NOA, so the conclusions reached are always accurate.