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.
- Return on equity (ROE) and return on assets (ROA) are two key measures to determine how efficient a company is at generating profits.
- The main differentiator between the two is that ROA takes into account leverage/debt, while ROE does not.
- ROE can be calculated by multiplying ROA by the equity multiplier.
Return on Equity (ROE)
Return on equity (ROE) is the net income divided by shareholder equity. It's a measure of profitability. The measure is often calculated using average equity over a period due to the mismatch in the income statement and balance sheet.
Return on Assets (ROA)
return on assets (ROA) is the net income divided by total assets. It's an efficiency measure of how well a company is using its assets. ROAs can vary based on the industry, thus, it's best to compare company ROAs that operate in similar industries, or to use ROA for historical analysis (comparing a company's current ROA to its previous ROA).
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.
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.
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.
The three-part DuPont analysis to calculate ROE is profit margin multiplied by asset turnover multiplied by the equity multiplier. The first part of the formula (profit margin times asset turnover) can be simplified to just ROA. Thus, ROE is calculated by multiplying ROA by the equity multiplier.
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. For 2021, Target (TGT) reported a ROA of 13.2%. Its equity multiplier was 3.9. Thus, its ROE came in at 51%.