Question

Explain how return on net operating assets (RNOA) and financial leverage (FLEV) affect Return on Equity (ROE). Is greater FLEV always better?

Answer 1

Return on equity is calculated as net income attributable to controlling interest divided by total stockholder's equity attributable to controlling interest. The ROE ratio is further divided into RNOA + (FLEV*Spread)*NCI ratio. RNOA calculates the return company has earned on its investment in net operating asset and FLEV is used to measure leverage of company. The higher RNOA would indicate higher profitability and thus the ROE of company would be higher based on the formula. Higher financial leverage mean company uses more of debt to finance the assets and thus equity of company would be lower and thus return on equity would be higher as denominator is lower. The higher RNOA and FLEV would increase ROE and lower RNOA and FLEV would decrease ROE.

A greater FLEV is not always better as it increases company's risk and thus the shareholders fund would be at risk as there is possibility that company would not be able to repay the debt. The credit risk of company increases and thus company should balance its financial leverage that is FLEV.