Return on Equity (ROE) vs. Return on Assets (ROA): An Overview
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 doing its job of managing the capital entrusted to it. The primary differentiator between ROE and ROA is financial leverage or debt. Although ROE and ROA are different measures of management effectiveness, the DuPont Identity formula shows how closely related they are.
The Formula for ROE:
ROE=Shareholder EquityNet Incomewhere:Shareholder Equity=Assets−Liabilities
The Formula for ROA:
ROA=Total AssetsNet Incomewhere:Total Assets=Shareholder Equity+Liabilities
ROE vs. ROA: Main Differences
The way that a company's debt is taken into account is the main difference between ROE and ROA. In the absence of debt, shareholder equity and the company's total assets will be equal. Logically, its ROE and ROA would also be the same.
But if that company takes on financial leverage, its ROE would be higher than its ROA. By taking on debt, a company increases its assets thanks to the cash that comes in. Assuming returns are constant, assets are now higher than equity and the denominator of the return on assets calculation is higher because assets are higher. ROA will therefore fall while ROE stays at its previous level.
ROE and The DuPont Identity
The DuPont identity explains the relationship between both ROE and ROA as measures of management effectiveness. It is a popular formula that gives insight into the components of a company's ROE. There are several iterations of the DuPont formula, the two- three- and five-part.
ROE=Profit Margin×Asset Turnover×SEwhere:SE=Shareholder equityProfit Margin=RevenueNet IncomeAsset Turnover=Total AssetsRevenueFinancial Leverage=SETotal Assets
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 called financial leverage, which is also known as the equity multiplier. A higher proportion of assets compared to shareholder equity demonstrates the extent to which debt (leverage) is used in a company’s capital structure.
Example of ROE and ROA
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 a ROA of 0.53%. Its financial leverage was 9.60. Using both equated to a ROE of 4.8%, which 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 of 2008-09, Bank of America reported ROE levels closer to 13% and ROA levels closer to 1%.
The Bottom Line
There are key differences between ROE and ROA that make it necessary for investors and company executives to consider both metrics when evaluating the effectiveness of a company's management and operations. Depending on the company, one may be more relevant than the other—that's why it's important to consider ROE and ROA in context with other financial performance metrics.