In business and accounting, the terms "return on assets" (ROA) and "return on equity" (ROE) are
two of the most important measures of profitability and performance. They are often used interchangeably, but
there is a big difference between the two. Here's a look at the key differences between ROA and ROE and
why they both matter to investors.
Return on assets (ROA) is a
measure of profitability that calculates how much a company earns (before taxes and interest) for every dollar
of assets it owns. ROA is also sometimes referred to as "return on investment" (ROI).
To calculate ROA,
you simply divide a company's net income by its total assets. For example, if a company has net income of
$100 million and total assets of $500 million, its ROA would be 20%.
ROA is a good measure of how
efficiently a company is using its assets to generate profits. All else being equal, a company with a higher
ROA is more profitable than a company with a lower ROA.
Return on equity (ROE) is a measure of profitability that calculates how much a company earns (before taxes
and interest) for every dollar of equity it has. Equity, for this purpose, is the same as shareholder's equity,
which is equal to a company's total assets minus its total liabilities.
To calculate ROE, you divide a
company's net income by its shareholder's equity. For example, if a company has net income of $100 million
and shareholder's equity of $500 million, its ROE would be 20%.
ROE is a good measure of how well a
company is using equity to generate profits. All else being equal, a company with a higher ROE is more
profitable than a company with a lower ROE.
Now that
you know how to calculate ROA and ROE, let's take a look at the key difference between the two measures.
ROA measures profitability in relation to all of a company's assets, while ROE measures profitability in
relation to equity only.
This may not sound like a big difference, but it is. To see why, let's
look at an example. Imagine two companies, Company A and Company B, each with $100 in assets and $50 in
liabilities. Company A has no equity, while Company B has $50 in equity.
Now let's say that both
companies earn $10 in net income. Company A's ROA would be 10% ($10/$100), while Company B's ROA would
be 20% ($10/$50).
At first glance, it might seem like Company B is more profitable than Company A.
However, this is not the case. Both companies are equally profitable when you look at their ROA. The only
difference is that Company B has more equity.
Now let's look at ROE. Company A's ROE would be 0%
($10/$0), while Company B's ROE would be 20% ($10/$50). In this case, Company B is indeed more profitable
than Company A. This is because ROE takes equity into account, while ROA does not.
ROE Both Matter
So why do both ROA and ROE matter? The answer is that they both provide valuable
information about a company's profitability.
ROA is a good measure of how efficiently a company is
using its assets to generate profits. This is important because it shows how well a company is managing its
resources. A company with a high ROA is usually doing a good job of using its assets to generate profits.
ROE is a good measure of how well a company is using equity to generate profits. This is important because
it shows how well a company is using the money that shareholders have invested. A company with a high ROE
is usually doing a good job of using equity to generate profits.
Both ROA and ROE are important
measures of profitability. They both provide valuable information about a company's performance.
Investors should look at both ROA and ROE when evaluating a company.
