At first look, these two measures may seem to be rather comparable because they both quantify a kind of return. Both measure an organization's capacity to make profits from its investments. However, they do not quite stand for the same thing in the same way. When examined more closely, these two ratios exhibit several important variations. When taken into consideration together, however, they provide a more accurate picture of how well a firm is doing.

Earnings per Share (ROE)

Investors look at and are one of the essential ratios. It is a fundamental evaluation of how efficiently the management of a firm spends the money provided by investors. The return on equity (ROE) reveals whether or not management is effectively increasing the firm's value. Let's determine the return on equity (ROE) for the made-up firm Ed's Carpets. According to Ed's financial statement for 2019, the company had a net income of $3.822 billion. When you look at the balance sheet for 2019, you'll see that the total shareholder equity was $25.268 billion. In 2018, that number was $6.814 billion.

Rate of Return on Assets

It provides a fresh perspective on management efficiency by indicating how much money a business makes for each dollar it has invested in its assets. This is a number that is very close to zero. In other words, the return on assets for this firm tells a significantly different tale about the company's success than the return on equity does. Stocks having a ROA of less than 5% are not likely to be considered by most experienced financial managers.

The Difference in Liabilities

Financial leverage, often known as debt, is the primary distinction between return on equity and return on assets. According to this equation, a corporation will have the same amount of equity in its shareholders as in its total assets if it does not have any debt. The return on equity, however, would be higher than the return on assets if the corporation used financial leverage. If we rephrase it differently, the equation for the balance sheet may help us understand why this is the case: Equity in the company may be calculated by subtracting liabilities from assets. A corporation may grow its assets by taking on more debt since this increases cash flow. But because equity is just assets less total debt, if a corporation takes on more debt, this will result in less equity for the company. In other words, a rise in debt will result in a decrease in equity, and given that equity is the denominator for ROE, an increase in ROE will result.

The total assets, which make up the denominator in return on assets calculations, go up if a corporation takes on more debt. As a result, the ratio of ROE to ROA is increased by debt. It should be clear from Ed's balance sheet why there was such a disparity between the company's return on equity and return on assets. The carpet manufacturer held a significant amount of debt, which enabled it to maintain a high level of assets while simultaneously lowering its stockholders' equity. In 2019, it had total liabilities that were more than $422 billion, which was more than 16 times the amount of total shareholders' equity it had, which was $25.268 billion. Because ROE only considers a firm's net income compared to its owners' equity for Corporate Health, it doesn't reveal anything about how efficiently a company spends its money from debt financings such as loans and bond offerings. A firm like this can generate an exceptional ROE even if they aren't genuinely better at using the shareholders' equity to develop the business. ROA is a useful metric that considers debt and equity in its denominator. Thus it may provide insight into how well a firm manages these funding sources.

The Bottom Line

Therefore, make sure that you take both ROE and ROA into consideration. They are distinct, but when taken collectively, they accurately show how well management is doing its job. A high ROE is a reliable indicator that management is doing a good job of earning returns from shareholders' capital, provided that ROA is robust and debt levels are manageable. The return on equity (ROE) is a "hint" that management provides shareholders with better value for their money. Conversely, a high ROE might give investors the wrong idea about the firm's prospects, particularly if ROA is low or if the company has a significant amount of debt.