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 entrusted to it. Below is an overview of the main differences between ROE and ROA and how they are related.
The primary differentiator between ROE and ROA is financial leverage or debt. The balance sheet's fundamental equation illustrates this fact: assets = liabilities + shareholders' equity. This equation indicates that, in the absence of debt, shareholders' equity and the company's total assets will be equal. Logically, their ROE and ROA would also be the same.
But if that company takes on financial leverage, ROE would rise above ROA. The balance sheet equation – if expressed differently – can illuminate the reasons why: shareholders' equity = assets - liabilities. By taking on debt, a company increases its assets, thanks to the cash that comes in. But since equity equals assets minus total debt, a company decreases its equity by increasing debt. In other words, when debt increases, equity shrinks, and since equity is the ROE's denominator, ROE, in turn, gets a boost.
The DuPont Identity
Looking at it another way, 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).
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.
What Are The Main Differences Between Return On Equity (ROE) and Return On Assets?
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 percent. Its financial leverage was 9.60. Using both equated to an ROE of 4.8 percent. This is a pretty low level: For banks to cover their cost of capital, ROE levels should be closer to 10 percent. Prior to the financial crisis of 2008-09, BofA reported ROE levels closer to 13 percent and ROA levels closer to 1 percent.
The Bottom Line
ROE and ROA are different measures of management effectiveness, but the DuPont identity shows how closely related they are.