The Interrelationships Between Return On Equity

Published Date: 02 Nov 2017

Equity is the total amount of cash that has been invested in the business by the owner. Return on Equity (ROE) is sometimes called "return on net worth." ROE is a financial ratio that shows how effective an investment the business is for its owners. It also reveals how much return a company earned in comparison to the total amount of shareholder equity found on the balance sheet. The formula for Return on Equity is equal to a fiscal year’s net income divided by total equity, expressed as a percentage.

The formula for ROE is:

ROE =

Return on Equity (ROE) is important for a business because the business can through the ROE to evaluate trends in a business such as profitability. ROE allows investors to compare a company’s use of their equity with other investments, and also can to compare the performance of companies in the same industry. When the businesses that has a high returns on equity, a businesses that pay off their stockholders handsomely and create substantial assets for invested.

When a company shows their increasing ROE in company suggests that a company is ability to generate profit without needing as much capital. It can determine the higher the ROE is better to a company and failing ROE is usually have a problem in a company.

Return on assets (ROA) is a financial ratio that shows the percentage of profit that a company earns in relation to its overall resources (total assets). It is commonly defined as net income divided by total assets. Net income is derived from the income statement of the company and is the profit after taxes. The assets are derived from the balance sheet and include cash and cash-equivalent items such as receivables, inventories, machinery, computer systems, vehicles, land, capital equipment as depreciated, and the value of intellectual property such as patents.

The formula for ROA is:

ROA =

Return on assets is use by a company to measures the amount of profit made by a company per dollar of its assets. Purpose ROA is to shows the company's ability to generate profits before leverage, rather than by using leverage. ROA measurements include all of a company's assets including those which arise from liabilities to creditors as well as those which arise from contributions by investors. Furthermore, ROA is gives an idea as to show how efficiently management use company assets to generate profit, but is usually of less interest to shareholders than some other financial ratios such as ROE.

ROA same with the ROE, it allows investors to compare a company with the same level of capitalization. A business has more capital-intensive will make that company more difficult to achieve a high ROA. The higher the ROA mean has the better the management in company. While falling ROA is almost always a problem management in company, but investors and analysts should bear in mind that the ROA does not account for outstanding liabilities.

Return on Equity (ROE) and Return on Assets (ROA) are very similar measures. The primary difference is that ROA is measuring the return to the total asset base of the operation and ROE is measuring the return only to the equity of the operation. Therefore, interest is not added back when computing ROE. As an operator, ROE represents return from the business.

Moreover, the difference between Return on Equity (ROE) and Return on Assets (ROA) is financial leverage, or debt. The balance sheet’s fundamental equation shows assets equal liabilities plus shareholders’ equity. This equation tells us that its shareholders' equity and its total assets will be the same when a company carries no debt. It follows then that their ROE and ROA would also be the same.

ROE would rise above ROA when the company takes on financial leverage. This is because a company increases its assets credit to the cash that comes in by taking on debt. A company decreases its equity by increasing debt. In other words, when debt increases, equity shrinks. At the same time, when a company takes on debt, the total assets increase. So, debt amplifies ROE in relation to ROA.

In the conclusion, Return on Equity (ROE) and Return on Assets (ROA) are different, but together they provide a clear picture of management's effectiveness. If ROA is sound and debt levels are reasonable, a strong ROE is a solid signal that managers are doing a good job of generating returns from shareholders' investments. ROE is certainly a "hint" that management is giving shareholders more for their money. On the other hand, if ROA is low or the company is carrying a lot of debt, a high ROE can give investors a false impression about the company's fortunes.