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• 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

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

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Page 1: 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

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• 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

Page 2: 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

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• 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

Page 3: 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

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• 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))

Page 4: 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

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• 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

Page 5: 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

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• 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

Page 6: 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

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• 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