The profitability ratios namely Return on equity (ROE) and return on assets (ROA) are the two important ratios for evaluating a company’s financial health, effective management, and performance.
Return on Assets (ROA)
Return on assets (ROA) measures a company’s profitability with its total assets. ROA can inform an investor about how effective the company management at generating profit from its assets. The greater the ROA, the better.
ROA = (Net Income / Total Assets) X 100
When a company’s ROA rises over time, it means it is generating more profit from each dollar it owns in assets. A declining ROA, on the other hand, indicates that a company has made poor investments, overspending, and may be in trouble.
ROA is not an effective tool for comparing companies of different sizes or industries. The best approach to use ROA is to look at a single business over time. Actively monitoring a company’s ROA can help investors figure out how well it’s doing over time.
Return on Equity (ROE)
Return on equity (ROE) is a financial performance metric determined by dividing net profits by shareholders’ equity. ROE is the return on net assets because shareholders’ equity equals a company’s assets minus its debt. Return on equity is an indicator of a corporation’s profitability in relation to stockholders’ equity.
If ROA looks at how well a company manages its assets to make profit, ROE looks at how well the company manages the money invested by its shareholders to make profit. Investors use ROE to determine the efficiency of their investments.
ROE = Net Income/ Stockholders’ Equity
What is a good ROA?
Experts usually say that a ROA of 5% or 10% is usually good, while 20% or higher means excellent. Generally speaking, the higher the ROA, the more efficient the company generates income. However, this number can be different depending on the sector of your company. It is good to check out competitors in the same industry.
For instance, a technology company may have a ROA of 15%, while an energy company could have a ROA of 8%. Comparing these two different industries to each other may not help you find a good ROA for either sector.
However, if you compared the technology company to its closest competitors, whose ROA indicator is below 10%, you might realize that it’s doing much better than its competitors. On the other hand, if you looked at other energy companies, you could find that many of them have ROAs closer to 15%, meaning that the company with 8% ROA is underperforming compared to other similar companies.
Example of ROE and ROA
In 2008-2009, one of the banking giants, Bank of America Corp (BAC), reported a ROA of 1% and ROE closer to 13%. In fact, the bank’s ROE should be closer to 10% to cover its cost of capital. Furthermore, due to the financial crisis, in 2013, Bank of America Corp reported a ROA of 0.53% and ROE around 4.8%. Of course, these numbers are significantly low levels if we compare the latest numbers to its own profitability history data.
While ROA is a useful metric, it isn’t the only way to assess a company’s efficiency and financial health. A company’s ROA is influenced by a variety of other factors, including market circumstances and demand, as well as the shifting cost of assets it requires. To gain a complete picture of a company’s overall financial health, ROA should be combined with other metrics such as ROE. Investors may draw conclusions on their investment efficiency using ROE, and complement it with the company’s efficiency in terms of assets using ROA.
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