Question

Assume that you are the CEO of a small publicly traded company. The operating performance of your company has fallen below market expectations, which is reflected in a depressed stock price. At your direction, your CFO provides you with the following recommendations that are designed to increase your company’s return on net operating assets (RNOA) and your operating cash flows, both of which will, presumably, result in improved financial performance and an increased stock price. , LO#2.1 #3.1 1. To improved net cash flows from operating activities, the CFO recommends that your company reduce inventories (raw material, work-in-process, and finished goods) and receivables (through selective credit granting and increased emphasis on collection of past-due accounts). 2. The CFO recommends that your company sell and lease back its office building. The lease will be structure so as to be classified as an operating lease under GAAP. The assets will, therefore, not be iincluded in the computation of the net ooperating assets (NOA), thus increasing RNOA. Evaluate each of the CFO recommendations. In your evaluation consider whether the recommendation will positively impact the operating pperformance of your company or whether it is cosmetic in nature.

Answer 1

Return on Net Operating Assets (RNOA) can be calculate by using the following formula:

  

Operating Income

= ----------------------------

Net Operating Assets

Return on net operating assets (RNOA) recognizes that profitability must be based on the net assets invested in operations. So firms can increase their operating profitability by convincing suppliers, in the course of business, to grant or extend credit terms; credit reduces the investment that shareholders would otherwise have to put in the business.

RNOA is operating income relative to net operating assets, and net operating assets are operating assets minus operating liabilities. So, the more operating liabilities a firm has relative to operating assets, the higher its RNOA.

There are two drivers of RNOA, they are:- 1. Operating profit margin 2. Asset turnover.

RNOA Analysis in the given Situation:-

1. As CFO suggested to increase the Net operating cash flows through realization of all liquid assets and decreasing the receivables period for shorter period. From the angle of RNOA these increases the net operating cash into the business, which ultimates increase in the RNOA ratio

2. One more recommendation is to sale and lease back transaction, which is well planned transaction, were assets will not decrease but classification of assets will be changed.

But in the view of yearly expenditure on the lease transaction has to be considered for the purpose of the above suggestion. Non-inclusion of lease transaction as per GAAP is just an accounting treatment. But physical existence of assets will be considered to determine the real value of all transactions.