Measurement with ROE and ROA
With all of the relationships investors throw around, it’s easy to get confused. Look at the return on equity (ROE) and return on investment (ROA). Since both measure some sort of return on investment, these two metrics seem pretty similar at first glance.
Both measure a company’s ability to generate income from its investments. But they don’t represent exactly the same thing. A closer look at these two relationships reveals some key differences. However, together they provide a clearer representation of a company’s performance.
ROA and ROE give a clear picture of corporate health
Return on equity
Of all the fundamental metrics investors look at, return on equity is one of the most important. It is a fundamental test of how effectively a company’s management is using investors’ money. The ROE shows whether management is increasing company value at an acceptable pace.
This financial ratio divides the company’s net income by its equity. The ROE is calculated as follows:
ROE=Average equityAnnual net income
The net profit can be found in the income statement and the equity appears at the bottom of the company’s balance sheet.
Let’s calculate the ROE for the fictional Ed’s Carpets company. Ed’s income statement for 2019 was $ 3.822 billion in net income. On the balance sheet, you can see that the total equity of shareholders for 2019 was $ 25.268 billion; In 2018 it was $ 6.814 billion.
To calculate ROE, divide 2019 and 2018 average equity ($ 25.268 billion + $ 6.814 billion ÷ 2 = $ 16.041 billion) and 2019 net income ($ 3.822 billion) by that average. You get a return on equity of 0.23 or 23%. This tells us that Ed’s Carpets made a 23% profit on every dollar invested by shareholders in 2019.
Many professional investors aim for a ROE of at least 15%.By that metric alone, Ed’s Carpets ‘ability to get profits out of shareholders’ money seems pretty impressive.
Return on investment
Now let’s turn to ROI, which offers a different view of management effectiveness and shows how much profit a company makes for every dollar of its assets. Assets include things like cash in the bank, accounts receivable, property, equipment, inventory, and furniture. ROA is calculated as follows:
ROA=Total assetsAnnual net income
You can also have Excel calculate this value.
Let’s take another look at Eds. You already know it made $ 3.822 billion in 2019 and you can find its total assets on the balance sheet. In 2019 Ed’s Carpets totaled $ 448.507 billion. Net income divided by total assets gives a return on assets of 0.0085, or 0.85%. This tells us that Ed’s Carpets made less than 1% profit in 2019 on the resources it owned.
This is an extremely low number. In other words, this company’s ROA tells a very different story about its performance than its ROE. Few professional asset managers will consider stocks with an ROA of less than 5%.
The difference lies in the liabilities
The big factor that separates ROE and ROA is financial leverage, or debt. How this is true is shown by the basic equation of the balance sheet: assets = liabilities + equity. This equation tells us that when a company is out of debt, its equity and total assets are the same. It follows that their ROE and ROA would also be the same.
However, if this company were to take financial leverage, the ROE would rise above the ROA. The balance sheet equation – in other words – can help us understand why: Equity = Assets – Liabilities.
By taking on debt, a company increases its wealth thanks to the inflow of cash. However, since equity is equal to assets minus total debt, a company decreases its equity by increasing debt. In other words, as debt increases, equity shrinks, and since equity is the denominator of ROE, ROE gets another boost.
When a company takes on debt, it also increases its total assets – the denominator of ROA. So debt increases the ROE in relation to the ROA.
Ed’s balance sheet was meant to show why the company’s return on equity and ROE were so different. The carpet maker had enormous debts that kept its wealth high while reducing equity. In 2019, it had total debt of over $ 422 billion – more than 16 times its total equity of $ 25.268 billion.
Because the ROE only weighs net income against owners’ equity, it doesn’t say much about how well a company uses its funding by borrowing and issuing bonds. Such a company can generate impressive ROE without using equity more effectively to grow the business. ROA, as its denominator includes both debt and equity, can help you see how well a company is using these two forms of financing.
The bottom line
So look at both ROA and ROE. They are different, but together they give a clear picture of the effectiveness of management. When the ROA is solid and the level of debt is reasonable, a strong ROE is a solid signal that managers are doing a good job of generating returns on shareholder investments.
ROE is certainly a “hint” that management is giving shareholders more for their money. On the other hand, when the ROA is low or the company has a lot of debt, a high ROE can give investors the wrong idea about the fortunes of the company.