A:

Return on equity (ROE) and return on assets (ROA) are two of the most important measures for evaluating how effectively a company’s management team is managing the capital that shareholders entrust to it. Below is an overview of the main differences between ROE and ROA and how they are related.

Understand ROE and ROA through the DuPont Identity

In a nutshell, ROE is ROA when adding financial leverage to the mix in a firm’s capital structure. The DuPont identity, a popular formula for dividing ROE into its core components, best explains the relationship between both measures of management effectiveness.

ROE = (net income) / (total assets) × (total assets) / (shareholders' equity)

The first half of the equation (net income divided by total assets) is the definition of ROA, which measures how efficiently management is using its total assets (as reported on the balance sheet) to generate profits (as measured by net income on the income statement).

The second half of the equation is known as financial leverage, which is also known as the equity multiplier. The primary balance sheet equation is:

Assets – Liabilities = Shareholders’ equity.

A higher proportion of assets compared to shareholders’ equity demonstrates the extent to which debt (leverage) is used in a company’s capital structure.

An Example

ROE and ROA are important components in banking for measuring corporate performance. Return on equity (ROE) helps investors gauge how their investments are generating income, while return on assets (ROA) helps investors measure how management is using its assets or resources to generate more income

In 2013, banking giant Bank of America Corp (BAC) reported an ROA level of 0.50%. Its financial leverage was 9.60. Using both equated to an ROE of 4.8%. This is a pretty low level. For banks to cover their cost of capital, ROE levels should be closer to 10%. Prior to the financial crisis, B of A reported ROE levels closer to 13% and ROA levels closer to 1%.

The Bottom Line

ROE and ROA are different measures of management effectiveness, but the DuPont identity shows how closely related they are.

At the time of writing, Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.

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