Marketers must understand the jargon of the boardroom if they are to contribute meaningfully to the critical strategic conversation. Too often they are sidelined by lack of this understanding, resulting in dumb choices being made by those who think strategy development and the deployment of these strategies is some form of hocus pocus.
Return on Assets (ROA) and Return on Equity (ROE) tell different stories about the quality of the management choices being made.
ROA is a measure of how effectively the enterprise is using the assets it has to generate a profit. It is the ratio of net income divided by total assets.
ROE is a measure of how effectively the enterprise is leveraging the use of the equity, capital supplied by the owners, to generate profits. It is the ratio of profits divided by equity.
Together they measure how well a management is doing at managing the enterprise on behalf of the owners. The major difference is the financial leverage delivered by the debt the enterprise uses to generate profits. The greater the distance between these two ratios the greater is the reliance on debt to fund activities. Conversely the closer they are, the less debt is on the balance sheet. In the absence of debt, the ROA and the ROE would be the same.
Every enterprise faces the choice of funding sources: debt or equity. If they choose to take on debt, or ‘financial leverage’ its ROE would be higher than its ROA only if the company earns more on the borrowed funds than the cost of borrowing.
You will often hear the term ‘financial engineering’. In its simplest form, it is the management of the balance between debt and equity, usually in response to interest rates, and expectations of those rates, and the expectations of dividends to be returned to shareholders out of profits.
I found the following example contained in an explanation of the ‘DuPont Identity’
Imagine a fictional company ABC with the following financials:
- Net Income = $1,000,000
- Average Total Assets = $4,000,000
- Average Shareholders’ Equity = $2,000,000
ROA = Net Income / Average Total Assets = $1,000,000 / $4,000,000 = 25%
ROE = Net Income / Average Shareholders’ Equity = $1,000,000 / $2,000,000 = 50%
In this example, ABC generates $0.25 in profit for each dollar of assets and $0.50 in profit for each dollar of shareholders’ equity. ROE is higher than ROA in this example, as it does not account for all assets, including debt. If total assets were equal to shareholder equity, then ROA and ROE would provide the same result.
As noted, while it may sound like accounting jargon, marketers simply must understand the terminology if they are to avoid being sidelined when it really counts.
