Many of those who run SME’s turn off when their accountant starts mumbling about ROE and ROA at the annual $500/hour financial roundup.
Understanding the difference is important to the long term health of the enterprise. They reflect 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 the amount of debt compared to equity is being used. Together they are a measure of the efficiency of the enterprises efforts to generate profit.
The difference is that ROA takes into account debt, while ROE does not.
Return on equity (ROE) is net income divided by shareholder equity. It measures profitability by relating how well a company generates profit from money invested by shareholders.
Return on assets (ROA) is net income divided by total assets. It’s an efficiency measure of how well a company is using its assets.
The difference is important for several reasons.
- ROE is focusses on the return generated on the shareholders’ equity. The easy analogy is the interest you receive on the balance in your bank account.
- ROA is focussed on the return generated on the total assets of the company, including debt.
In the absence of debt, ROE and ROA would be the same.
Viable businesses are able to make choices about the financial leverage they apply to their operations. The mix of debt and equity they employ.
A business that no longer has that option, in other words, investors have better options to generate a return on their funds, they will be withdrawn. At that point it often becomes difficult to borrow to replace the withdrawn equity, so the business becomes progressively unable to fund operations. At that point, it requires a ‘restructure’, or goes into liquidation.
Leverage works both ways.
ROE is used by investors to assess the profitability relative to their investment.
ROA is used to assess management’s efficiency in using all the enterprises assets, both debt and equity to generate profits.
