Reviewed by Somer Anderson
Return on Equity (ROE) vs. Return on Assets (ROA): An Overview
Return on equity (ROE) and return on assets (ROA) are two of the most important measures for evaluating how effectively a company’s management team is doing its job of managing the capital entrusted to it. The primary differentiator between ROE and ROA is financial leverage or debt. Although ROE and ROA are different measures of management effectiveness, the DuPont Identity formula shows how closely related they are.
Key Takeaways
- Return on equity (ROE) and return on assets (ROA) are two key measures to determine how efficient a company is at generating profits.
- The main differentiator between the two is that ROA takes into account leverage/debt, while ROE does not.
- ROE can be calculated by multiplying ROA by the equity multiplier.
Return on Equity (ROE)
Return on equity (ROE) is net income divided by shareholder equity — Excel can help with the calculation. ROE measures profitability by relating how well a company generates profit from money invested by shareholders. Due to the mismatch in the income statement and balance sheet, it is often calculated using average equity over a period.
Return on Assets (ROA)
Return on assets (ROA) is net income divided by total assets. It’s an efficiency measure of how well a company is using its assets. ROAs can vary based on industry; thus, it’s best to compare company ROAs that operate in similar industries or use ROA for historical analysis (comparing a company’s current ROA to its previous ROA).
Key Differences
There are key differences between ROE and ROA. The first one is perspective. ROE focuses on the return generated on the shareholders’ equity while ROA focuses on the return generated on the total assets of the company, including debt. In the absence of debt, ROE and ROA would be the same.
But if that company takes on financial leverage, its ROE would be higher than its ROA only if the company earns more on the borrowed funds than the cost of borrowing.
Hence, by taking on debt at a cost lower than the return generated with the borrowed money, a company increases its assets with debt.
There are key differences between ROE and ROA that make it necessary for investors, lenders, and company executives to consider both metrics when evaluating the effectiveness of a company’s management and operations. ROE is often used by investors to assess the profitability relative to shareholders’ investment. ROA is used to evaluate management’s efficiency in using all assets ( debt and equity) to generate earnings.
ROE and the DuPont Identity
The DuPont identity explains the relationship between ROE and ROA as measures of management effectiveness. It is a popular formula that gives insight into a company’s ROE components. According to the DuPont identity, ROE is affected by three things:
- Operating efficiency — measured by profit margin
- Asset use efficiency — measured by total asset turnover
- Financial leverage — measured by the equity multiplier
The three-part DuPont analysis to calculate ROE is profit margin multiplied by asset turnover multiplied by the equity multiplier. The first part of the formula (profit margin times asset turnover) can be simplified to just ROA. Thus, ROE is calculated by multiplying ROA by the equity multiplier.
Example of ROE and ROA
Imagine a fictional company ABC with the following financials:
- Net Income = $1,000,000
- Average Total Assets = $4,000,000
- Average Shareholders’ Equity = $2,000,000
ROA = Net Income / Average Total Assets = $1,000,000 / $4,000,000 = 25%
ROE = Net Income / Average Shareholders’ Equity = $1,000,000 / $2,000,000 = 50%
In this example, ABC generates $0.25 in profit for each dollar of assets and $0.50 in profit for each dollar of shareholders’ equity. ROE is higher than ROA in this example, as it does not account for all assets, including debt. If total assets were equal to shareholder equity, then ROA and ROE would provide the same result.
When Does it Mean if ROE and ROA Are Different?
When ROE and ROA are different, this means that a company is using financial leverage to boost its income. The greater the difference, the larger the liabilities the company is using as leverage to generate growth. The smaller the difference, the less debt a company has on its balance sheet.
What is a Good ROA and ROE?
What determines a good ROE or ROA can vary depending on the industry, the age of a company, and broader market conditions. Generally speaking, many industries consider 15%-20% to be a strong ROE, meaning a company is using shareholder equity effectively to generate profit. Meanwhile, 5%-10% is generally considered to be a good ROA, while an ROA below 1% often signals financial weakness.
What Are the Components of the Three-Part DuPoint Identity?
Net profit margin, total asset turnover, and the equity multiplier make up the three-part DuPont identity. These parts can be further broken down as:
- Net Profit Margin = Net Income / Revenue (Sales)
- Total Asset Turnover = Revenue (Sales) / Average Assets
- Equity Multiplier = Average Assets / Average Shareholder Equity
The Bottom Line
ROE and ROA are important components in banking for measuring corporate performance. Return on equity (ROE) helps investors gauge how their investments are generating income, while return on assets (ROA) helps investors measure how management is using its assets or resources to generate more income.