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Return on assets (ROA) and return on equity (ROE) are profitability ratios used by investors and analysts to gauge a company’s financial performance before their investments. This article gives a basic understanding and comprehensive examples of ROA and ROE.
Return on assets reveals the effectiveness of how a company generates net income from its asset management. The higher ROA number, the more money a company earns from less investment. ROA is an important operational metric for investors/analysts/bankers to gauge a business performance by looking at the earnings generated from its invested capital.
Return on assets formula: ROA = Net Income/Total Assets
Net Income = Revenue – Expenses
Total Assets = Total Liabilities + Shareholder’s Equity
Net Income is recorded in Income Statement while Total Asset is from Balance Sheet.
ROA is best used to compare similar companies or a business’s precious performance.
Return on equity shows how effectively a company turns equity investments into profit. An increasing ROE means the company is good at using shareholder value to generate profits while a decreasing ROE shows the inefficiency in utilizing equity.
Return on equity formula: ROE = Net Income/Shareholder’s Equity
Net Income is found on Income Statement (a summary of revenue and expenses) while Shareholder’s Equity comes from Balance Sheet (a report of company’s total assets and liabilities)
Company A | Company B | |
Net Income | $100,000,000 | $80,000,000 |
Total Assets | $500,000,000 | $100,000,000 |
ROA | 0.2 | 0.8 |
Company B generates better profits from its total assets than company A.
ROE example
Company A | Company B | |
Net Income | $8000 | $8000 |
Shareholder’s equity | $16000 | $12000 |
ROE | 0,5 | 0,7 |
Company B is better than company A in terms of utilizing their shareholder’s equity to generate profit assuming that the two companies are in the same industry.
3.1 Uses of ROA
ROA can be used to compare companies with different capital structures without any adjustment because it effectively captures the influence of both equity and debt financing on asset purchases and its ability to generate profits.
Due to the inclusion of liabilities, ROA is a valuable internal management ratio to evaluate the benefits of investing in a new system versus expanding the current operations. A good ROA will show an increase in productivity/income and cost optimization.
3.2 Uses of ROE
Investors often use ROE as one of valuation tools for companies as it is a snapshot of company’s management. ROE takes earnings data and turns it into a very relevant measurement that can be compared across sectors though the drastic change of earnings and profit margins make it difficult to compare companies across sectors. Businesses having higher ROE than its industry are considered to be outstanding.
Industry Name | Number of firms | ROE (unadjusted) | ROE (adjusted for R&D) |
Advertising | 61 | 2.93% | 2.45% |
Aerospace/Defense | 72 | 8.54% | 6.90% |
Air Transport | 17 | -47.03% | -46.40% |
Apparel | 51 | -8.19% | -8.12% |
Auto & Truck | 19 | 4.49% | 2.39% |
Auto Parts | 52 | -14.31% | -11.47% |
Bank (Money Center) | 7 | 7.41% | 7.41% |
Banks (Regional) | 598 | 8.22% | 8.22% |
Beverage (Alcoholic) | 23 | 10.10% | 10.10% |
Beverage (Soft) | 41 | 28.86% | 27.83% |
Broadcasting | 29 | 0.24% | 0.24% |
Brokerage & Investment Banking | 39 | 12.08% | 12.07% |
Building Materials | 42 | 20.54% | 18.13% |
Business & Consumer Services | 169 | 6.81% | 6.72% |
Cable TV | 13 | 11.47% | 11.40% |
Chemical (Basic) | 48 | -1.82% | -1.73% |
Chemical (Diversified) | 5 | 13.25% | 11.52% |
Chemical (Specialty) | 97 | 2.50% | 2.20% |
Coal & Related Energy | 29 | -41.66% | -41.62% |
Computer Services | 116 | 13.50% | 11.03% |
Computers/Peripherals | 52 | 50.53% | 29.56% |
Construction Supplies | 46 | 13.20% | 10.77% |
Diversified | 29 | 10.62% | 10.12% |
Drugs (Biotechnology) | 547 | -1.19% | 1.30% |
Drugs (Pharmaceutical) | 287 | 18.98% | 11.98% |
Education | 38 | -5.66% | -5.29% |
Electrical Equipment | 122 | 17.67% | 14.62% |
Electronics (Consumer & Office) | 22 | -4.89% | -1.67% |
Electronics (General) | 157 | 6.67% | 5.48% |
4.1 ROA limitations
ROA can not be used to evaluate companies across industries because of the difference in underlying assets. Some companies use Net Income while others apply their operating income which misleads the comparison among different companies. This ratio is the most suitable for banks as the bank balance sheet captures the real value of their assets and liabilities (based on Mark-to-Market method).
ROA is limited to service-based companies and capital intensive industries. Specifically, service-based companies have a low investment in assets which leads to higher ROA. Capital intensive companies are required to invest a large proportion of profit to maintain existing property and equipment which results in low ROA.
4.2 ROE limitations
ROE should not be used to gauge the financial performance of early-stage companies. Companies with potential future value often have negative Net Income in the first few years of their burning cash flow stage. Thus, the negative ROE of these companies does not give any insights of investment for analysts. Investors should consider the time share capital has been raised to assess their profitability.
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