ROA and ROE Give Clear Picture Of Corporate Health
Return on equity indicates if a company’s value is growing at an acceptable rate. It’s calculated as annual net income divided by average shareholders’ equity.Say Ed’s Carpets’ net income is $3.822 billion. That same year, stockholder equity is $25.268 billion, and was $6.814 billion the previous year. To get the ROE, average the shareholders’ equity, which would be $16.041 billion, and divide that number into the company’s net income.Ed’s Carpets generates a 23% profit on every dollar shareholders invest. Since many investors are looking for at least a 15% ROE, Ed’s is doing well.Return on assets reveals how much profit a company earns for every dollar of assets. It’s calculated as annual net income divided by total assets.Ed’s has $448.507 billion worth of assets. Its ROA is 0.85% — a low number. Few money managers will consider stocks with an ROA below 5%.The big factor that separates ROE and ROA is debt. By taking on debt, a company increases its assets by the cash that comes in. But since equity equals assets minus total debt, a company decreases its equity by increasing debt. In other words, when debt increases, equity shrinks, and ROE gets a boost. And when a company takes on debt, total assets and ROA increase. This is why BOTH numbers must be considered when evaluating a company’s performance. Debt amplifies ROE in relation to ROA.In Ed’s case, a large amount of debt kept its assets high while reducing shareholders’ equity.If ROA is sound and debt levels are reasonable, a strong ROE shows managers are doing a good job of generating returns.
Reviewed by Margaret JamesReviewed by Margaret James
Measuring With ROE and ROA
With all the ratios that investors toss around, it’s easy to get confused. Consider the return on equity (ROE) and return on assets (ROA). Because they both measure a kind of return, at first glance these two metrics seem pretty similar.
Both gauge a company’s ability to generate earnings from its investments. But they don’t exactly represent the same thing. A closer look at these two ratios reveals some key differences. Together, however, they provide a clearer representation of a company’s performance.
Return on Equity
Of all the fundamental ratios that investors look at, one of the most important is the return on equity. It’s a basic test of how effectively a company’s management uses investors’ money. ROE shows whether management is growing the company’s value at an acceptable rate.
This financial indicator divides the company’s net income by the shareholders’ equity. ROE is calculated as:
ROE=Average Shareholders’ EquityAnnual Net Income
You can find net income on the income statement, and shareholders’ equity appears at the bottom of the company’s balance sheet.
Let’s calculate ROE for the fictional company Ed’s Carpets. Ed’s 2024 income statement puts its net income at $3.822 billion. On the balance sheet, you’ll find total stockholder equity for 2024 was $25.268 billion; in 2023 it was $6.814 billion.
To calculate ROE, average shareholders’ equity for 2024 and 2023 ($25.268bn + $6.814bn ÷ 2 = $16.041 bn), and divide net income for 2024 ($3.822 billion) by that average. You will arrive at a return on equity of 0.23, or 23%. This tells us that in 2024 Ed’s Carpets generated a 23% profit on every dollar invested by shareholders.
Many professional investors look for an ROE of at least 15%. So, by this standard alone, Ed’s Carpets’ ability to squeeze profits from shareholders’ money appears rather impressive.
Return on Assets
Now, let’s turn to return on assets, which, offering a different take on management’s effectiveness, reveals how much profit a company earns for every dollar of its assets. Assets include things like cash in the bank, accounts receivable, property, equipment, inventory, and furniture. ROA is calculated like this:
ROA=Total AssetsAnnual Net Income
You can also have Excel calculate this value for you.
Let’s look at Ed’s again. You already know that it earned $3.822 billion in 2024 and you can find total assets on the balance sheet. In 2024, Ed’s Carpets’ total assets amounted to $448.507 billion. Its net income divided by total assets gives a return on assets of 0.0085, or 0.85%. This tells us that in 2024 Ed’s Carpets earned less than 1% profit 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 money managers would consider stocks with such a low ROA.
The Difference Is All About Liabilities
Companies and analysis use many measurements to determine a company’s profitability. ROE shows performance based on shareholder equity. ROA shows company profitability based on its total assets. The return on debt (ROD) measures how much a company profits from borrowed or leveraged funds. The big factor that separates ROE and ROA is financial leverage or debt.
The balance sheet’s fundamental equation shows how this is true: assets = liabilities + shareholders’ equity. This equation tells us that if a company carries no debt, its shareholders’ equity and its total assets will be the same. It follows then that their ROE and ROA would also be the same. If that company takes on financial leverage, ROE would rise above ROA. The balance sheet equation—if expressed differently—can help us see the reason for this: shareholders’ equity = assets – liabilities.
By taking on debt, a company increases its assets, thanks to the cash that comes in. Therefore, when looking at ROA, the numerator (return) would stay the same, but the denominator (assets) would increase. Therefore, the ratio of returns to assets would decrease.
Alternatively, when taking on debt, a company’s returns and equity both remain unchanged. Taking on debt on changes a company’s assets via the cash they accept and a company’s liabilities via the obligation they accept. Therefore, ROE remains unchanged when a company takes on debt, while a company’s ROA likely decreases (disregarding future impacts to revenue).
Ed’s balance sheet should reveal why the company’s return on equity and return on assets were so different. The carpet-maker carried an enormous amount of debt, which kept its assets high while reducing the proportional amount of shareholders’ equity. In 2024, it had total liabilities that exceeded $422 billion—more than 16 times its total shareholders’ equity of $25.268 billion.
Because ROE weighs net income only against owners’ equity, it doesn’t say much about how well a company uses its financing from borrowing and issuing bonds. Such a company may deliver an impressive ROE without actually being more effective at using the shareholders’ equity to grow the company. ROA, because its denominator includes both debt and equity, can help you see how well a company puts both these forms of financing to use.
The Bottom Line
So, be sure to look at ROA as well as ROE. They are different, but together they provide a clear picture of management’s effectiveness. If ROA is sound and debt levels are reasonable, a strong ROE is a solid signal that managers are doing a good job of generating returns from shareholders’ investments.
ROE is certainly a “hint” that management is giving shareholders more for their money. On the other hand, if ROA is low or the company is carrying a lot of debt, a high ROE can give investors a false impression about the company’s fortunes.
Correction–Jan. 30, 2023: A previous version of this article incorrectly stated that equity decreases which causes ROE to change when debt is incurred. In reality, taking on debt does not change equity in absolute dollars, so ROE would not change.
Read the original article on Investopedia.