How ROA and ROE help in analysing corporate health?

It’s a no brainer for an investor to look into the financial ratios before making investment decisions, as there are no single measures to tell the whole story, making informed investment decisions could be tricky and may rattle your grey cells.

ROA and ROE are two of the widely popular ratios used to measure corporate health and performance.

Seemingly close, both the ratios tend to indicate a company's ability to generate earning on its investments, but this gives rise to a million-dollar question "What's the difference?" and if so, which one is better?

Let's dive in deep to understand these key metrics closely, starting with ROA.

ROA

ROA or Return on Assets is a measure that indicates how profitable a company is with respect to the assets it holds and controls. For the investors, this measure helps them to understand how efficient a company's management is to use its assets effectively to generate profit. ROA can be calculated as –

For instance, consider yourself as an investor trying to analyze two companies' performances, ABC and XYZ in the same industry. With Rs. 20 Crores as its total assets and Rs. 4 Crores of net income last year, company ABC is the bigger company whereas Company XYZ has total assets of Rs. 10 Crores and Rs. 3 Crores as the annual net income. Applying the ROA formula, ROA of company ABC is 0.2 or 20%, whereas company XYZ ROA is 0.3 or 30%.

This indicates that company XYZ is much more efficient in using its assets to generate earnings despite being a smaller company. You, as an investor, will be much keener on investing in company XYZ, looking at the ROA. However, the key take away here is it's crucial to keep the type of industry in mind for ROA considerations. As the manufacturing industry holds and controls many more assets to that of an accounting or banking firm, this may vary ratios and should be considered carefully.

ROE

ROE or Return on Equity is a measure that indicates how a company efficiently utilizes its investor’s funds to generate earnings or profit. In simple terms, it measures how efficient a company is in generating profits. ROE is calculated as –

For instance, lets again consider company ABC and XYZ with both having an annual net income of 10 Crores. Each company has equity holdings of Rs. 50 crores and Rs. 25 crores, respectively. By applying the ROE formula shows that Company ABC's return on equity is 0.2 or 20%, while ROE of company XYZ is 0.4 or 40%. This gives you the understanding that the management of company XYZ is using the equity of the company much more efficiently compared to company ABC. Therefore, company XYZ will be more favorable to invest.

What’s the difference?

The main differentiator between ROA and ROE lies in the usage of debt to acquire additional assets, also known and financial leverage. ROE fails to give a clear picture of how well a company uses debts as it only takes into the net consideration income with respect to its owner's equity, which may be misleading. But when it comes to ROA, it takes into consideration both debt and equity, which gives a more accurate view of the company's actual performance and effectiveness of management to use both forms of funds.

Take Away

A sign of smart Investors is that they don't rely on a single measure to analyze corporate health. It's good practice to consider both ROA and ROE to make informed investment decisions, as both are critical financial metrics. Low debt level with Good ROA and ROE is recommended or in Finology, as we say "#AcchiWaliAdvice." Higher debt, with low ROA, is an alarming situation for an investor.

Happy Investing!