The Relationship Between Return on Assets & Shareholders' Equity & Leverage

by Sue-Lynn Carty

The relationship between return on assets (ROA), shareholders equity and leverage is a company's profits. ROA is a measure of profitability as it relates to assets, while shareholder's equity is the overall profitability of a company and leverage is a tool companies use to generate additional profits.

ROA

A company's ROA demonstrates its ability to use its assets to earn a profit. Corporate executives calculate ROA by dividing the company's net income by its total assets. Basically, the ROA of a company is the amount of profit it generates for every $1 in assets it owns. For example, if a company's net income is $50 and its assets total $100, then the ROA is $50/$100 = .50. This means that the company generates $0.50 in profits for every $1 it owns in assets.

Shareholders' Equity

The shareholders' equity of a company is a measure of its net worth and is calculated by subtracting a company's total assets from its total liabilities. The different sources of capital that make up shareholders' equity are the capital the company received from investors at its inception, the capital the company received from selling common and preferred stock and the retained earnings from its business operations. Retained earnings is the company's retained net income that it does not use to pay dividends to its shareholders.

Leverage

It is not unusual for a company to borrow money by obtaining a loan to increase profits. When a company borrows money, it may use those funds to purchase investments that present the potential to earn a high return, which increases profits. A company may also purchase a fixed asset by borrowing, rather than pulling from its cash accounts. By borrowing instead of paying for the asset out of its cash accounts, the company can potentially purchase more fixed assets than it could if it paid cash.

Leverage Example

Leveraging by borrowing money to make an investment may mean a company obtains a loan with a 10-percent interest rate and invests that money in an investment that earns a return of 15 percent. In another example, say a company bakes cakes and can purchase one new stove with cash and each new stove generates an additional $100 in profits. Now, say the owner obtains a loan to purchase five new stoves. By using leverage, the owner can generate an additional $500 in profits instead of $100 in additional profits if he had paid cash and purchased only one stove.

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