Calculative & Disaggregating ROA
and ROCE
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Sumit Goyal
MBA-4th Sem
Financial Statement Analysis
• Financial statement analysis is often divided
into two sub-parts: profitability analysis and
risk analysis. This is a natural division since
much of our thinking about firm performance
is influenced by our study of the relationship
between risk and return in finance.
Profitability measures
• A. Return on assets (ROA)
• B. Return on common equity (ROCE)
Risk measures
• A. Short-term liquidity
• B. Longer-term solvency
ROA
• The return on assets measures the return
generated by the firm (a measure of income)
relative to the assets used to generate that
income. ROA measure how productively the
resources (assets) of the firm are used.
ROA
• ROA = Net income + (1-t )*Interest expense + MI in earning
Average total assets
• Terms:
– t - Marginal statutory tax rate (found in footnotes)
– Interest expense - From income statement (or footnotes if
shown net on income statement)
– MI in earnings - Earnings belonging to minority interest in
consolidated subsidiaries; often not material enough to show
on income statement.
– Average total assets - Usually from comparative balance
sheets.
Disaggregating ROA
ROA can be defined as the product of two other ratios:
1. Profit margin ratio, and
2. Total assets turnover
ROA = Profit margin * Asset turnover
Profit margin = Net income + (1-t )*Interest expense + MI in earnings
Sales
Asset turnover = Sales
Average total assets
Profit Margin Ratio
• Profit margin ratio measures a firm's ability to
control its expenses relative to its sales.
• We expect expenses to grow as sales grow, but not
as fast.
• A high profit margin ratio is preferred to a low one.
Profit margin = Net income + (1-t )*Interest expense + MI in earnings
Sales
Total Assets Turnover
• Total assets turnover measures a firm's ability to
generate sales from a given level of assets.
• A large asset turnover is preferred to a low one.
• Total assets turnover is related to three similar
ratios
a. Accounts receivable turnover
b. Inventory turnover
c. Fixed asset turnover
Asset turnover = Sales
Average total assets
Disaggregating Asset Turnover
• Accounts receivable turnover = Credit
sales/Average accounts receivable
• Inventory turnover = COGS/Average
inventory
• Fixed asset turnover = Sales/Average fixed
assets (net)
ROCE
• It measures the return available to common
stockholders relative to the book value of their
investment in the firm. Here the capital structure
of the firm makes an important difference, since
the return to common stockholders is net of
payments to bondholders and preferred
stockholders. In essence, ROCE tells us how
effective the firm is in using both its resources
(assets) and its financing (leverage) in creating
wealth for common shareholders.
ROCE
ROCE = Net Income - Preferred Dividends
Average Common Equity
• Terms:
– Net income - Usually income from continuing
operations; may or may not include restructuring costs
(the same as for ROA)
– Preferred dividends - Dividends due to preferred
shareholders for the period
– Average common equity - Total stockholders' equity
less all traces of preferred stock; weight if necessary
Disaggregating ROCE:
ROCE = ROA * (CEL) * (CSL)
• CEL (Common earnings leverage) =
Net income - Preferred dividends
Net income + (1-t )*Interest expense + MI in earnings
• CSL (Capital structure leverage) =
Average total assets
Average common equity
