Return on equity (roe) and return on assets (roa) are two of the most important measures for evaluating how effectively the management of the company manages the capital that the shareholders trust. Below is an overview of the main differences between roe and roa and how they are connected.
The DuPont Identity
In a nutshell, ROE ROA when you add leverage to the mix in the capital structure of the firm. DuPont identity, popular formula to divide ROE into its basic components, best explains the relationship between the two indicators of management efficiency.
The roe = (net profit) / (total assets) × (assets) ÷ (shareholders)
The first half of the equation (net income divided by total assets) is the definition of ROA, which measures how efficiently management uses its assets (as reported on the balance sheet) for profit (as measured by net profit income).
The second half of the equation is called financial leverage, which is also known as capital multiplier. The basic balance sheet equation:
Assets – liabilities = equity
A higher share of assets compared to equity characterizes the degree of debt (leverage) used in the capital structure of the company.
Roe and roa are important components in the banking sector to assess corporate performance. Return on equity (roe) helps investors gauge how their investments are generating income and return on assets (roa) helps investors to evaluate how management using its assets or resources to generate more income.
In 2013, banking giant Bank of America Corp. (BAC) reported ROA level of 0.50%. Financial leverage 9.60. Using both equal to the ROE 4.8%. It’s pretty low: for banks to cover the cost of capital, the level of ROE should be closer to 10%. Before the financial crisis of 2008-09, Used this level of ROE is closer to 13% and ROA of around 1%.
Roe and roa are several different measures of management efficiency, and the DuPont identity shows how closely related.
At the time of writing, Ryan C. Fuhrmann did not own shares of any companies mentioned in this article.