Question

Is ROA a better performance measurement than ROE? Discuss.

Answer 1

Return on assets (ROA) is profitability ratio which measures how effectively a business has used its assets to generate profit. It is calculated by dividing net income for the period by the average total assets. ROA measures cents earned by a business per dollars of its total assets.

Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders' equity. Because shareholders' equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets. ROE is considered a measure of how effectively management is using a company’s assets to create profits.

ROE IS BETTER PERFORMANCE MEASUREMENT THAN ROA.

One major difference between ROE and ROA is debt. If there is no debt, shareholder’s equity and total assets of the company will be same. This means that in this scenario, ROE and ROA will be equal. Now if the company decides to take a loan, ROE would become greater than ROA. A higher ROE is not always an indicator of an impressive performance of a company. In this regard, ROA is a better indicator of the financial performance of a company.

It is prudent to have a look at both ROE as well as ROA to come to a conclusion about the financial health and performance of a company. Both provide a different perspective, but when the results of the two are combined, they provide a clear picture of the effectiveness of the management of any organization. With a high ROA and manageable debt, if ROE is also high it means that the company is generating decent profits using shareholder’s money. But if ROA is low and there is huge debt carried by the company, even a high ROE can only be a misleading figure.

Return on Assets (ROA) to Quantify Management Effectiveness

ROA = Net Income / Total Assets

ROA looks closely at how efficiently the business is using shareholder assets to earn returns.

But ROA ignores the capital structure (debt vs equity) of a business so a single ROA value doesn’t hold much value.

You need to compare ROA over a period of time (3 or 5 years) and compare it with competitors within the same industry.

Since ROA varies significantly from industry to industry, keep it within direct competition.

ROA can also be re-written as

ROA = Net Profit Margin x Total Asset Turnover

ROA = (Net Income/Revenue) x (Revenue/Total Assets)

Return on Equity (ROE) to Measure Management Effectiveness

ROE = Net Income / Shareholders Equity

This is a basic test to see how management uses shareholders money.

Obviously, a low number is not desirable.

But you can get more information about management than whether they are earning a good rate of return off shareholder money.

By using ROE to it’s fullest potential, it provides a wealth of insight into management behavior.