Both return on equity (ROE) and return on assets (ROA) measure performance, but sometimes they tell a very different story. This is why they’re best used together.

Do ROA and ROE Truly Reflect the True State of Corporate Health?

When it comes to evaluating a company's financial health, investors and analysts often turn to metrics like return on equity (ROE) and return on assets (ROA). These ratios are critical tools in assessing a company's ability to generate earnings from its investments and assets. However, it's essential to recognize that these metrics, while related, reveal distinct aspects of a company's financial health. By delving into the nuances of ROE and ROA, we can gain a more comprehensive understanding of a company's true performance.

Measuring With ROE and ROA

ROE, or return on equity, is a fundamental ratio used to gauge how efficiently a company's management employs investors' capital. It assesses whether a company is growing its value at an acceptable rate. The formula for ROE is:

ROE = Annual Net Income / Average Shareholders' Equity

Shareholders' equity represents the residual interest in the assets of the company after deducting liabilities, and it can be found at the bottom of the balance sheet. To calculate ROE, you take the company's net income from the income statement and divide it by the average shareholders' equity over a specific period. A higher ROE indicates better profitability in relation to shareholder investments.

For example, let's consider a fictional company, Ed's Carpets. In 2019, Ed's Carpets reported a net income of $3.822 billion, and its shareholders' equity for 2019 and 2018 was $25.268 billion and $6.814 billion, respectively. The average shareholders' equity over this period would be ($25.268 billion + $6.814 billion) / 2 = $16.041 billion. Therefore, Ed's Carpets had an ROE of 0.23 or 23%. An ROE of at least 15% is often considered favorable, indicating efficient use of shareholder funds.

On the other hand, ROA, or return on assets, takes a different approach to assess management effectiveness by measuring how much profit a company earns for each dollar of its assets. The ROA formula is:

ROA = Annual Net Income / Total Assets

Total assets encompass the company's resources, including cash, accounts receivable, property, equipment, inventory, and more. A higher ROA suggests that a company is generating significant profits relative to its asset base.

Continuing with our example of Ed's Carpets, with $3.822 billion in net income and total assets of $448.507 billion in 2019, the company's ROA is 0.0085 or 0.85%. An ROA of less than 5% is generally considered less favorable, indicating that the company is not efficiently utilizing its assets to generate profits.

The Difference Is All About Liabilities

The key factor that differentiates ROE from ROA is financial leverage or debt. This distinction stems from the fundamental accounting equation: assets = liabilities + shareholders' equity. In a debt-free scenario, a company's shareholders' equity and total assets would be identical, resulting in similar ROE and ROA figures. However, when a company takes on financial leverage, ROE surpasses ROA.

By incurring debt, a company increases its assets, thanks to the influx of cash. As a result, when calculating ROA, the numerator (return) remains constant, while the denominator (assets) rises, reducing the ratio of returns to assets.

Conversely, when a company assumes debt, its returns and equity remain unaltered. The only changes occur in the company's assets due to the received cash and liabilities due to the obligations. Therefore, ROE remains unaffected by debt, while ROA typically decreases.

To illustrate this, Ed's Carpets had an extensive amount of debt, with total liabilities exceeding $422 billion in 2019, more than 16 times its total shareholders' equity of $25.268 billion. This significant debt load inflated the company's assets but reduced the proportion of shareholders' equity, resulting in the disparity between its ROE and ROA.

In summary, while ROE primarily focuses on net income relative to shareholders' equity, it provides limited insight into how effectively a company leverages financing from borrowing and bond issuance. A company may boast an impressive ROE without being more efficient in using shareholders' equity to grow the business. ROA, on the other hand, factors in both debt and equity in its denominator, offering a more holistic view of how efficiently a company deploys both forms of financing.

In practice, investors should consider both ROE and ROA when evaluating a company's financial health. When these metrics align, it suggests that the company is managing its assets and equity effectively. However, when there is a substantial gap between the two, it may indicate that the company's financial structure, particularly its debt levels, significantly influences its financial performance. Therefore, a comprehensive analysis should encompass both ROE and ROA to gain a more accurate picture of a company's true state of corporate health.

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