Turn on equity roe n on equity roe is the principal

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TURN ON EQUITY (ROE) n on equity (ROE) is the principal summary measure of company performance and is - ed as follows: ROE = Net income Average stockholders' equity E relates net income to the average investment by shareholders as measured by total stock- rs' equity from the balance sheet. n Buffett highlights ROE as part of his acquisition criteria: "Businesses earning good s on equity while employing little or no debt." The ROE formula can be rewritten in a way tter see the point Buffett is making (derivation of this ROE formula is in Appendix 3A): ROE = Operating return + Nonoperating return equation above shows that ROE consists of two returns: (1) the return from the company's ~~ti'ng activities, linked to revenues and expenses from the company's products or services, - _) the return from the company's use of debt, net of any return from nonoperating invest- . Companies can use debt to increase their return on equity, but this increases risk because failure to make required debt payments can yield many legal consequences, including bank- y. This is one reason why Warren Buffett focuses on companies whose return on equity is - .ed primarily from operating activities. BUSINESS INSIGHT Target's ROE and RNOA .: - V.- - V - V - ,--- - r-- r----- - V r-- r----- - V r-- ,--- - ~7- -; V--'/----- - e following graph shows that arget's ROE and RNOA have eased steadily in the past years. ROE exceeds RNOA all years, widening more in the two years as the company eased the nonoperating return ponent of its ROE. 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 2010 2011 2009 L01 Compute return on equity (ROE) and disaggregate it into components of operating and nonoperating returns.
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3-5 Module 3 I Profitability Analysis and Interpretation ALERT The FASB has released a preliminary draft of proposed new financial statements to, among other things, better distinguish operating and nonoperating activities. It appears that the FASB recognizes the crucial importance of distinguishing between operating and nonoperating activities for analysis purposes. OPERATING RETURN (RNOA) Operating returns are reflected in the return on net operating assets (RNOA) , defmed as follows: Net operating profit aftertax (NOPAT) RNOA = -~-----"~-----'---:----"--:- Average net operating assets (NOA) To implement this formula, we must first classify the income statement and balance sheet into operating and nonoperating components so that we can assess each separately. We first consider operating activities on the income statement and explain how to compute NOPAT. Second, we consider operating activities on the balance sheet and explain how to compute NOA. Operating Items in the Income Statement -NOPAT The income statement reports both operating and nonoperating activities. Exhibit 3.1 shows a typical income statement with the operating activities highlighted. Operating and Nonoperating Items in the Income Statement Typical Income Statement Opera!ir;Jglt/ilrns High!ighted Revenues Cost of sales Gross profit Operating expenses Selling, general and administrative Asset impairment expense Gains and losses on asset disposal Total operating expenses Operating income Interest expense Interest
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