When it comes to evaluating the financial performance of a company, the two most commonly used metrics are Return on Assets (ROA) and Return on Equity (ROE). Both of these metrics help investors and other stakeholders understand how well a company is managing its assets and equity, however, there are some important differences between the two. In this blog post, we’ll explore the differences between ROA and ROE, and how investors can use these metrics to better understand the financial performance of a company. We’ll also discuss how these metrics can be used to assess the potential value of a company’s investments and provide insights into the company’s long-term financial health. Finally, we’ll discuss how ROA and ROE can be used in tandem to make more informed investment decisions.
Example of calculating ROA
An example of ROA would be:
Becs Umbrellas is a company that designs and manufactures umbrellas. Becs Umbrellas reported $6 million in revenue for 2020. According to its balance sheet, the company had assets totaling $13 million, including shareholder equity and liabilities. Becs Umbrellas can calculate its ROA using the equation above:
ROA = $6 million / $13 millionROA = 0. 46 or 46%.
This means that Becs Umbrellas made 46% of its profit from the return on its assets
What is ROA?
The term “ROA” stands for return on assets, which refers to how profitably a company uses its assets. Assets can be:
You can use the following equation to determine your return on assets:
ROA = annual net income / total assets
Your shareholder equity, or the assets you own, and your liabilities, or the assets you acquired by incurring debt, are included in this formula as part of your total assets.
Example of calculating ROE
Here is an example of calculating ROE:
According to Becs Umbrella’s income statement, it earned $6 million in 2020. It listed $7 as its shareholder equity on its balance sheet. 4 million in 2020 and $5. 6 million in 2019. Becs Umbrellas can calculate the average stockholders equity by averaging the equity for 2019 and 2020:
Average shareholder equity = ($7. 6 million + $9. 4 million) / 2Average shareholder equity = $8. 5 million.
The average shareholder equity can then be entered into the ROE equation by Becs Umbrellas as follows:
ROE = $6 million / $8. 5 millionROE = 0. 70 or 70%.
During this time period, Becs Umbrellas had a 70% return on its shareholders investments
What is ROE?
The term “ROE” refers to a company’s annual return on net assets, or return on equity. Businesses view the return on equity (ROE) as a gauge of how well a company is using its shareholders’ equity. Based on the company’s average shareholders equity over a year, it calculates the return on the investors’ investments. The criteria for what constitutes a good ROE vary by industry, and in order to demonstrate your success, you typically want to try to achieve your industry’s average ROE. You can use this equation to calculate ROE:
ROE = annual net income / average shareholder equity
On a company’s income statements, you can find its net income, and at the bottom of its balance sheet, its shareholder equity. While businesses compute their income statements once a year, the balance sheet is a continuously updated document that calculates costs and assets. In order to compare average shareholder equity to annual net income more easily, it is best practice to calculate average shareholder equity to reflect the entire year. However, you might need to access balance sheets from various accounting periods in order to calculate the average shareholder equity. If not, use the following equation to determine shareholder equity:
Shareholder equity = assets – liabilities
Liabilities in this equation are accounts that you owe money on, such as loans, accounts payable, and mortgages.
Differences between ROA vs. ROE
When assessing a company’s success, investors consider both ROA and ROE, but each metric offers very different insights. The two metrics, return on assets and return on equity, differ in the following ways:
Purpose
One distinction between return on equity and return on assets is that debts are taken into account when calculating return on assets. In order to acquire assets, you must either use your equity or take on debt. Adding assets to your business is equivalent to adding value, while accruing debt is equivalent to taking value away. Your debt is deducted from your assets, so the fewer assets you can list in your ROA, the more debt you have. Both a company’s ROE and ROA would be equal if it had no debt.
A sound business strategy is to take on debt in order to build up assets, and many companies do so in order to finance expansion. However, your return on assets decreases as your debt load increases. This is so that ROA can compare your returns to your liabilities or debts. A company may have too much debt if its return on equity is significantly higher than its return on assets.
Measures of success
Both ROE and ROA metrics assess a company’s investment potential, but they provide different insights into the business. By itself, ROA can reveal whether a business is effectively managing its assets. If a company’s ROA is low, it may indicate that its assets have not been used effectively. This may be because it has incurred too much debt.
ROE can demonstrate how well a company manages its equity, but the number can be deceptive. A company can use its equity to return profits by having a high ROE. It may also mean a low equity share, which would present a greater risk to investors. Even with a high ROE, a company may still have too much debt to generate significant returns, so you can have a high ROE and still have a low ROA. Therefore, it’s crucial to take a company’s debts into account when calculating its ROE.
Similarities between ROA vs ROE
Here are some similarities between the two metrics:
Usefulness
Both metrics can be used by investors and business leaders to assess a company’s success. They can assist investors in understanding the management team’s strengths, which they can then communicate to other stakeholders. Company executives can assess this information and use it to guide their strategic management decisions.
Comparison
When compared to companies of similar size and industry, both metrics can offer useful information about a company’s ability to generate returns. By comparing two businesses in the same size and sector, investors can more accurately understand the ROA and ROE of one company when determining its value. This can prevent skewed comparisons between mismatched businesses.
For instance, because it is new and hasn’t had time to pay off its initial start-up costs, a startup may have more debt and less equity. As a result, comparing the success of this business to that of one that has been around for 50 years would be inaccurate.
The DuPont identity
The DuPont identity is an additional formula for calculating ROE. The formula looks like this:
ROE = profit margin x asset turnover x equity multiplier
Each variable in the DuPont identity has its own calculation:
While the asset turnover portion of the equation measures the company’s asset use, the profit margin component of the equation accounts for the operating efficiency of the business. The equity multiplier compares assets to shareholder equity to determine the company’s financial leverage. By considering three different ratios, the elements of the DuPont identity collaborate to thoroughly analyze a company’s ROE.
Here is an example using the Becs Umbrellas example to calculate the DuPont identity:
Using this formula, Becs Umbrellas can determine its profit margin if it has $10 million in revenue and $6 million in net income:
Profit margin = 0 Profit margin = $6,000,000/$10,000,000 6 or 60%.
After that, it can calculate the asset turnover by adding the $13 million in assets owned by the business:
Asset turnover is equal to $10 million divided by $13 million. 76 or 76%.
The equity multiplier will then be determined using this formula and the disclosed $7. 4 million in shareholder equity:
Equity multiplier = $13 million / $7. 4 millionEquity multiplier = 1. 75 or 175%.
The last step is to combine to find the ROE:
ROE = 60% x 76% x 175%
ROE = 79.8%
Becs Umbrellas determines that the DuPont identity yields a ROE of 79. 8% based on the three ratios included in the formula.
Return on Assets (ROA) and Return on Equity (ROE) – Fundamental Analysis
FAQ
What is the difference between ROE and ROA?
Return on Assets (ROA) is net income divided by average assets, whereas Return on Equity (ROE) is typically net income divided by equity. There you have it. The calculations are pretty easy.
Which is better ROA or ROE?
ROA = Net Profit/Average Total Assets. Higher ROE does not impart impressive performance about the company. A better way to assess a company’s financial performance is to look at its ROA. The combination of higher ROE, higher ROA, and manageable debt is yielding respectable profits.
What does the ROA tell us?
Return on assets (ROA), also known as return on total assets, is a metric used to determine how much money a company makes using its capital. This profitability ratio illustrates the rate of growth in profits produced by a company’s assets in percentage terms.
