By: Tom Hannagan
I was hoping someone would ask about this. Return on Equity (ROE) is generally net income divided by equity, while Return on Assets (ROA) is net income divided by average assets. There you have it.
The calculations are pretty easy. But, what do they mean? ROA tends to tell us how effectively an organization is taking earnings advantage of its base of assets. This used to be the most popular way of comparing banks to each other — and for banks to monitor their own performance from period to period. Many banks and bank executives still prefer to use ROA…though typically at the smaller banks.
ROE tends to tell us how effectively an organization is taking advantage of its base of equity, or capital. This has gained in popularity for several reasons and has become the preferred measure at larger banks. One huge reason for the growing popularity of ROE is, simply, that it is not asset-dependent. ROE can be applied to any line of business or any product. You must have “assets” for ROA, since one cannot divide by zero.
This flexibility allows banks with differing asset structures to be compared to each other, or even for banks to be compared to other types of businesses. The asset-independency of ROE also allows a bank to compare internal product line performance to each other. Perhaps most importantly, this permits looking at the comparative profitability of lines of business like deposit services. This would be difficult, if even possible, using ROA.
If you are interested in how well a bank is managing its assets, or perhaps its overall size, ROA may be of assistance. Lately, what constitutes a good and valid portrayal of assets has come into question at several of the largest banks. Any measure is only as good as its components. Be sure you have a good measure of asset value, including credit risk adjustments.
ROE on the other hand looks at how effectively a bank (or any business) is using shareholders’ equity. Many observers like ROE, since equity represents the owners’ interest in the business. Their equity investment is fully at risk compared to other sources of funds supporting the bank. Shareholders are the last in line if the going gets rough. So, equity capital tends to be the most expensive source of funds, carrying the largest risk premium of all funding options. Its deployment is critical to the success, even the survival, of the bank. Indeed, capital allocation or deployment is the most important executive decision facing the leadership of any organization. If that isn’t enough, ROE is also Warren Buffet’s favorite measure of performance.
Finally, there are the risk implications of the two metrics. ROA can be risk-adjusted up to a point. The net income figure can be risk adjusted for mitigated interest rate risk and for expected credit risk that is mitigated by a loan loss provision. The big missing element in even a well risk-adjusted ROA metric is unexpected loss (UL). Unexpected loss, along with any unmitigated expected loss, is covered by capital. Further, aside from the economic capital associated with unexpected loss, there are regulatory capital requirements. This capital is left out of the ROA metric. This is true at the entity level and for any line-of-business performance measures internally.
Since ROE uses shareholder equity as its divisor, and the equity is risk-based capital, the result is, more or less, automatically risk-adjusted. In addition to the risk adjustments in its numerator, net income, ROE can use an economic capital amount. The result is a risk-adjusted return on capital, or RAROC. RAROC takes ROE to a fully risk-adjusted metric that can be used at the entity level and that can also be broken down for any and all lines of business within the organization. As discussed in the last post, ROE and RAROC help a bank get to the point where they are more fully “accounting” for risk – or “unpredictable variability”.
Sorry about all of the alphabet soup, but there is a natural progression that I’m pointing to that we do see banks working their way through. That progression is being led by the larger banks that need to meet more sophisticated capital reporting requirements, and is being followed by other banks as they get more interested in risk-adjusted monitoring as a performance measurement. The better bank leadership is at measuring risk-adjusted performance, using ROE or RAROC, the better leadership can become at pricing for all risk at the client relationship and product levels.
FAQs
The Difference Is All About Liabilities
What is the key difference between a returns to assets ROA and returns to equity ROE measure? ›
In summary, ROA measures how well a company uses assets to generate earnings, while ROE measures the return to shareholders on their equity investment. The two metrics offer different but complementary views into a company's profitability and efficiency.
What is ROE vs ROCE vs ROA vs ROI? ›
Synopsis. Investors often check Return on Capital Employed (ROCE), Return on Investment (ROI), Return on Asset (ROA) and Return on Equity (ROE) to understand how much value for money they would get if they invested in a particular company.
Is the concept of ROA the same with ROI explain your answer? ›
Return on Assets (ROA) is a type of return on investment (ROI) metric that measures the profitability of a business in relation to its total assets. This ratio indicates how well a company is performing by comparing the profit (net income) it's generating to the capital it's invested in assets.
What is a good return on assets ratio percentage? ›
A ROA of over 5% is generally considered good and over 20% excellent. However, ROAs should always be compared amongst firms in the same sector. For instance, a software maker has far fewer assets on the balance sheet than a car maker.
What happens if ROE is higher than 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.
Is ROE or ROA more important for investors? ›
While a high ROE indicates a company's ability to generate profits for its shareholders, a high ROA shows how efficiently it utilizes its assets to generate those profits. Both metrics provide valuable insights into a company's financial health, but they should not be considered in isolation.
Which is better ROI or ROE? ›
If you want to determine if you made the right, wrong, or even a brilliant investment in a revenue-driving activity, ROI will be more relevant to you. However, ROE is generally seen as a more accurate measure of a company's profitability as it considers its net income.
What is one important difference between ROA and ROCE? ›
ROCE is best used to compare companies in capital-intensive sectors—i.e. those companies that carry a lot of debt. Return on assets (ROA), unlike ROCE, focuses on the efficient use of assets. These profitability ratios are best used to compare similar companies in the same industry.
How do you calculate return on assets? ›
Although there are multiple formulas, return on assets (ROA) is usually calculated by dividing a company's net income by the average total assets. Average total assets can be calculated by adding the prior period's ending total assets to the current period's ending total assets and dividing the result by two.
The single biggest difference between ROA and ROE is that ROA takes into account a company's debt, while ROE doesn't. If a company doesn't have any debt, these two numbers would be the same for that company.
What does Roa and Roe tell us? ›
Return on equity (ROE) and return on assets (ROA) determine how efficient a company can be at generating profits. Both formulas that can help investors determine how good a company is at turning a profit.
What does a return on assets of 12.5% represent? ›
What does a return on assets of 12.5% represent? A return on assets (ROA) of 12.5% means that for every $100 of total assets on the company's balance sheet, it generates $12.50 in net income.
Is 5% return on assets good? ›
A good return on assets is in the 10% range. Anything above that is excellent and below 5% is considered harmful. A company with a ROA of 15% or higher is doing very well, while one with 1% or lower is likely in trouble. If the return on assets is less than one, you lose money.
Is 3% a good return on assets? ›
ROA is often used in the business world to measure a company's financial health. Typically, a 'good' ROA for a company could be anything between 5% and 20%.
What is a bad equity to asset ratio? ›
If the ratio value is higher than the value of 2, it is considered harmful, and typically, it shows that the company has a lot of debt and most of its assets are stuck.
What are the main differences between ROI and ROE? ›
ROI and ROE in an investment portfolio
ROI measures if it's worth pursuing a revenue-generating activity, and ROE measures your company's profitability. Both figures are an indication of the overall financial health and performance of your company.
What is the difference between return on equity and return on assets quizlet? ›
ROE considers the capital structure of a company, while ROA does not. DuPont framework tells you that ROE is ROA times leverage multiplier. The leverage multiplier represents the capital structure of the company.
What is the difference between return on capital and ROE? ›
Return on equity (ROE) measures a corporation's profitability in relation to stockholders' equity. Return on capital (ROC) measures the same but also includes debt financing in addition to equity.
What's the difference between assets and equity? ›
Equity and assets both provide value to a company and help it operate and generate profits. While assets represent the value the company owns, equity represents investment provided in exchange for a stake in the company.
