Financial Indicators Worth Knowing (ROE, ROA)

A financial ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. There are many standard ratios used to try to evaluate the overall financial condition. The two most famous of them are presented in this article.

Return on Equity (ROE)- your financial performance

Broadly speaking, your Return on Equity (ROE) is a measure of your financial performance. Return on equity (ROE) is the measure of a company's net income divided by its shareholders' equity. ROE is considered to be a measure of a corporation's profitability and effectiveness in generating profits. The higher the ROE, the more effective the management of the company in terms of revenue generation and growth from equity financing.

ROE is expressed as a percentage and can be calculated for any company as long as both Net Income and Equity are positive numbers. Since equity equals assets minus liabilities, ROE is essentially a measure of the return that is generated on a company's net assets.

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It is considered best practice to calculate ROE based on the average equity over the period due to the mismatch between the profit and loss account and the balance sheet.

A good rule of thumb is to aim for an ROE that is equal to or slightly above the average for the company's sector - those in the same industry.

High ROE cannot always be positive. A large ROE can indicate a number of problems, such as inconsistent profits or over-indebtedness. Also, negative ROE due to the company's net loss or negative equity cannot be used for company analysis or for comparison with companies with positive ROE.

Whether ROE is considered good or bad will depend on what is normal for listed companies. Relatively high or low ROE ratios will vary significantly by industry group or sector. On the other hand, industries with relatively few players and where only limited assets are needed to generate revenue may exhibit higher average ROE.

Return on Assets (ROA)

By definition, return on assets (ROA) refers to a financial ratio that indicates how profitable a company is in relation to its total assets. Corporate management, analysts, and investors can use ROA to determine how efficiently a company uses its assets to generate a profit.

Business is about efficiency. Comparing profits to revenues is a useful operational measure, but comparing them to the resources a firm used to obtain them shows the reality of that firm's existence. A higher ROA means that the company is more efficient and effective in managing its balance sheet to generate profits, while a lower ROA indicates that there is room for improvement.

Investors can use ROA to find stock opportunities as the ROA shows how efficiently a company is using its assets to generate profits.

ROA is calculated by dividing a company's net income by its total assets, and is expressed as:

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The main limitation of ROA is that it cannot be used across industries. This is because firms in one industry have a different asset base than firms in another.

ROE vs ROA

Both ROA and return on capital (ROE) measure how well a company is using its resources. But one of the key differences between the two is the way they treat the company's debt. ROA depends on how leveraged the business is or how much debt it has. On the other hand, ROE measures only the return on equity of the company, which ignores its liabilities. So ROA is a debt of the company and ROE is not. The more leverage and debt the company takes, the higher the ROE will be relative to the ROA.

 

Source: textbook "Financial Analysis In Practice"