Derivation of the Financing Leverage Equation

The financing leverage equation identifies the contribution of operating activities and financing activities to return on common equity, ROE. Here is the derivation of the equation. ROE is called ROCE (Return on Common Equity) here as a reminder that preferred equity is effectively debt for the common shareholder.

So, ROCE is a weighted return to operating activities and financing activities:

or,

RNOA &nbsp= OI (After tax) / NOA                   (Return on Net Operating Assets)

FLEV &nbsp &nbsp= NFO / CSE                         (Financial Leverage)

NBC&nbsp&nbsp= NFE (after tax) / NFO        (Net Borrowing Cost)

SPREAD&nbsp= RNOA – NBC                           (Operating Spread)