FSA Ratio Analysis (Purpose)

ROE

ROE measures how efficiently the firm generates profit from common shareholders’ equity, indicating overall shareholder profitability.

Why must ROE be decomposed?

ROE can be driven by operating performance or financial leverage. Decomposition reveals whether returns are sustainable or driven by risk.

RNOA

RNOA measures profitability from core operations, independent of financing decisions, reflecting the quality of operating performance.

Why is RNOA a higher-quality metric than ROE?

RNOA isolates operating performance by removing the effects of leverage, making it more useful for comparing firms’ core business strength.

What does financial leverage measure?

Leverage measures the extent to which the firm uses debt and other financial obligations to amplify returns to equity holders.

What is the spread in the Advanced DuPont model?

Spread is the difference between RNOA and the net borrowing cost. A positive spread indicates that debt increases shareholder value.

What does a negative spread imply?

A negative spread implies the firm earns less on operations than it pays to lenders, meaning leverage destroys shareholder value.

What does gross margin measure?

Gross margin measures profitability after direct production costs, reflecting pricing power and production efficiency.

Product Gross Margin

Product gross margin indicates profitability of physical goods, reflecting manufacturing efficiency and product pricing strength.

Why are services margins typically higher?

Services have low incremental costs and recurring revenue, making them highly scalable and profitable.

What does operating margin capture?

Operating margin captures profitability after operating expenses, reflecting cost discipline and operating leverage.

Why is NOI margin used in RNOA?

NOI margin isolates core operating profitability, excluding financing and non-operating items.

What does TAT measure?

Total asset turnover measures how efficiently the firm uses its assets to generate revenue.

What does PPE turnover indicate?

PPE turnover indicates how efficiently physical assets are used to generate sales.

What does high receivables turnover imply?

High receivables turnover implies fast collections, strong customer credit quality, and better cash flow management.

What does high inventory turnover indicate?

High inventory turnover indicates efficient inventory management and strong product demand.

What does low accounts payable turnover indicate?

Low accounts payable turnover indicates delayed payments to suppliers, effectively using supplier financing.

What does free cash flow to all investors (FCFF) measure?

FCFF measures cash generated by operations available to both debt and equity holders.

What does free cash flow to common equity (FCFE) measure?

FCFE measures cash available to common shareholders after meeting all operating and financing obligations.

Why are FCFF and FCFE both important?

FCFF is used for enterprise valuation, while FCFE is used for equity valuation.

How does the Advanced DuPont model explain ROE?

ROE is driven by operating profitability (RNOA), financial leverage, and the spread between operating returns and borrowing costs.

How can a firm improve RNOA?

A firm can improve RNOA by increasing operating margins, increasing asset turnover, or both.

Why do these ratios matter for valuation?

These ratios explain the sustainability of cash flows and returns, which directly affect firm value and stock price.