Same profit, different base
Both ratios start from net income. Return on assets (ROA) measures it against everything the business uses to operate, however that is financed. Return on equity (ROE) measures it against only the part financed by shareholders. Because total assets equal liabilities plus equity, a business with any liabilities has less equity than assets, so for a profitable business its ROE is higher than its ROA.
The two are linked by the equity multiplier, average total assets divided by average shareholders’ equity: ROE = ROA × equity multiplier, as long as both use the same period and the same averages. That link is the last step of a DuPont analysis.
An example
A business earns net income of $12,000. Its average total assets are $150,000 and its average shareholders’ equity is $60,000. ROA is 12,000 ÷ 150,000 = 8.0%. ROE is 12,000 ÷ 60,000 = 20.0%. The equity multiplier is 150,000 ÷ 60,000 = 2.5, and 8.0% × 2.5 = 20.0%.
If the same business had funded all its assets with equity, ROA and ROE would both be 8.0%. The extra 12 percentage points of ROE come from financing most of the assets with liabilities.
When to use which
- Use ROA to compare how productively businesses use their assets, independent of how they are financed.
- Use ROE to see the return earned on shareholders’ money.
- Read them together. A high ROE with a much lower ROA means much of the return comes from borrowing, which also adds risk if profits fall.
- When shareholders’ equity is negative, ROE is not meaningful, but ROA can still be calculated.
Summary
| ROA | ROE | |
|---|---|---|
| Numerator | Net income | Net income |
| Denominator | Average total assets | Average shareholders’ equity |
| Affected by debt | Only through interest in net income | Yes: more liabilities means less equity and a higher ROE |
| Answers | How much profit do the assets generate? | How much profit is earned on shareholders’ investment? |