ROA and ROE, what they are, formulas and how to relate them.

ROA (Return on Assets) and ROE (Return on Equity) are the following ratios profitability ratiosThey relate elements of a company's Income Statement to elements of the Balance Sheet at a cut-off date, in order to obtain indicators related to the benefit granted by the company to its investors.

‍

What is ROA?

ROA is the return on assets ratio, which relates EBIT, or operating earnings before interest and taxes, to the company's total assets.

In this ratio, EBIT represents the amount of monetary units that remain in the company, when total operating expenses are deducted from the company's total revenues, directly derived from its own principal activities, including the deduction of depreciation and amortization, all before interest or financial expenses and taxes.

The figure for operating profit, i.e. EBIT, is compared with the figure for total assets on the balance sheet at the same date. The percentage between the two values gives the rate of earnings per total assets.

ROA can then be defined as the monetary units earned for each monetary unit of investment made in the company, therefore, this ratio measures the efficiency of management in utilizing all the assets in the company to generate operating profits.

The objective of ROA is to determine the capacity to remunerate the total assets invested in the business activity.

‍

How to calculate ROA? Formula.

To calculate ROA there is a simple formula, which relates EBIT to total assets. We can see it below. 

ROA = EBIT / Total Assets

The ideal ROA value should be above 5% to demonstrate business viability.

‍

What is ROE?

ROE is the return on equity ratio, which relates the net profit or result for the current year to the company's total equity, i.e., to its capital, plus reserves, plus results from previous years and results for the current year.

ROE is also called financial profitability ratio, since it relates the behavior of several factors and shows the return on equity.

The purpose of ROE is to measure the company's capacity to remunerate its owners or shareholders.

For investors, the ROE represents the opportunity cost of the funds they keep invested in the company and makes it possible to compare, at least initially, with the returns they can obtain in other alternative investments.

ROE is one of the most important ratios in corporate finance, because it allows comparing returns, regardless of the sector or jurisdiction in which the company operates.

‍

How to calculate ROE? Formula.

In order to calculate the ROE there is a simple formula, which we can see below.

ROE = Net Profit / Net Equity

The ROE value obtained is compared with the ROE value projected by the investors or compared with the ROE value of other projects, to analyze the opportunity costs of the investments.

‍

Related content

• Economic and financial management of a company
• Financial audit of a company
• Financial Risks: What are they, types and how to manage them?

‍

How are ROA and ROE related?

In order to maximize financial profitability or ROE, it will depend on an increase in net profit and a lower contribution of capital and results, i.e., the company's own funds. 

However, net profit basically depends on the company's EBIT generation, which leads to the conclusion that the maximization of ROE depends in turn on the increase in economic profitability and the financing structure.

It is essential to use ROA and ROE to evaluate the company's actual profitability situation. The comparison of these two indicators will determine the optimal financial structure for the company's growth.

The financial leverage effect is the result of the relationship between the company's own and external sources of financing and the effect it has on the company's results. Management should consider active management of financial leverage, given the effect it has on the financial profitability or ROE of shareholders or owners.

The financial leverage effect consists of observing the difference between ROE and ROA for efficient decision making. The result can be:

- Positive: ROE higher than ROA. In this case, part of the assets have been financed with debt, thus achieving a growth in financial profitability.

- Nil or Zero: ROE equals ROA. In this case, the company has no debt, because all assets are financed with equity, either capital contributed by its owners or profitability obtained by the company.

- Negative: ROE lower than ROA. In this case, the average cost of debt is higher than the economic profitability obtained by the company.

‍