Although financial ratios can never give the complete picture of a business, they do make a good benchmark for monitoring purposes, and can alert an investor to potential problems. The return on assets and return on equity ratios are both measurements of profitability and efficiency. They can reveal how well a company utilizes it's financing and assets to create income. In general, an ROA greater than the ROE is a sign of trouble.
Return on Assets
The ROA is the sum of the net income and interest expenses divided by the company's average asset value for the period. Analysts add the interest expenses back into the equation to better gauge the results of company activities without the cost of financing. The ROA expresses how well a company uses it's assets to make money. But this number can vary significantly with the accounting method for asset depreciation and expense amortization, which is the rate at which an asset loses book value when expenses are factored in.
Return on Equity
ROE takes net income and subtracts any preferred dividends to arrive at a true income for the period. It then divides this number by the shareholder's equity, or value of company assets minus company liabilities. Shareholder equity is essentially the accumulated profit over time, so the ROE measures how efficiently management uses that accumulated profit to make more money. This number is often compared to the cost of any debt. This shows how the company is financing its operations, and if it's using retained earnings to pay off debts or for business activities.
ROA vs. ROE
Remember that ROA includes the cost of financing. If ROA is greater than ROE, it means that financing is costing more than it makes. In other words, the company isn't making enough profit on borrowed funds to cover the cost of the interest on those funds. It's easy to see how this could be a problem over time. After all, the whole point of borrowing money is to make profits, not interest payments.
It's important never to consider ROA and ROE numbers in a vacuum. For example, a company in an expansion phase might post a low ROE if the activities funded by new financing haven't yet begun to pay off in the form of profit. Or, if you take out a loan to buy a new machine that manufactures a new product, it may be some time before those new product sales are enough to cover the cost of the financing on the machine. ROA and ROE also don't reflect risk as they can't tell you if management is taking risks with the business to attain a particular ratio, which is a practice that may cause long-term harm. Financial ratios should always be taken in context with the rest of the financial reports for the period as well as the company's history over time.
- Principals of Accounting; Financial Reporting and Concepts; Larry Walther, Ph.D., CPA, CMA
- University of Notre Dame; Financial Ratio Analysis; Barry Keating
- Cotton Inc.; Long-Term Trend Analysis; Amanda Blocker, Gregg Ibendahl, and John Anderson
- CUNA CFO Council; ROE vs. ROA as a Measurement Goal; December 5, 2005