Profitability Ratios: Return on Assets (ROA) and Return on Equity (ROE)

Suppose you are reviewing the financials for USA Motors and Autocar. USA Motors has a net income of $10M and average assets of $100M. Autocar has a net income of $5M and average assets of $70M. From the information above, which of the two companies has a better return on assets?

Correct.

No.

But something is troubling you as you examine ROA data. You are interested in the returns these companies are getting from operations. Financing decisions regarding how they paid for assets don't factor into operations. But what is clouding the picture is that the interest paid to lenders who financed the assets is deducted from net income. Looking again at the financial data on USA Motors and Autocar, you notice both had similar incomes and asset levels, but USA had a much higher interest expense. What can you do to clarify things and get a comparable ROA from operations for these two companies?

Not correct. This amount has already been deducted from net income, so you want to add it back.

Correct. Adding it back to income will eliminate the impact of interest paid to those who financed the assets. You will have an ROA number from operations.

Think for a minute about the new formula for ROA from operations and look at the table below. | USA Motors | | |-----------------------|------| | Net income | $10M | | Interest expense | $3M | | Tax rate | 33% | | Average assets | $100M | Is the ROA you calculate from the new formula above greater or less than the one that you did before for basic ROA?

Incorrect.

Correct.

The correct calculation for ROA is 10/100 or 10%. The ROA from operations is $$\displaystyle \frac{10 + 3(1 - 0.33)}{100} = 12 \% $$, so it is greater. Since this adjustment adds to net income in the numerator, ROA from operations will be a larger number.

The calculation is USA Motors 10/100 = 0.10 or 10%. Autocar is 5/70 = 0.0714 or 7.14%. USA Motors has the greater ROA.

Adding back the interest expense will create a different formula. ROA from operations is $$\displaystyle \text{ROA} =\frac{\text{net income + interest expense} (1-\text{tax rate})}{\text{average total assets}}$$. This will get you a better metric for judging operational results. You might also want to eliminate the tax impacts entirely and use EBIT, earnings before interest and taxes, in the numerator.

Net income is what the company earns after paying all of its expenses. This profit is what just _shareholders_ have a claim on as owners of the company. So __return on equity (ROE)__ is often a more useful measure from an owner's perspective. The broadest measure of return on equity is: $$\displaystyle \text{ROE} = \frac{\text{net income}}{\text{average total equity}}$$. The average is often based on the beginning and ending of the period during which the net income was earned, just as in the case of ROA.

Average total equity includes all equity such as preferred and common equity. How might net income need to be adjusted to focus on the returns to common stockholders?

Incorrect. Adding in the preferred stock dividends would mean that those dividends are part of the common stockholder's return. These dividends only go to preferred shareholders.

Correct. Since preferred dividends are paid to preferred shareholders, those returns are credited only to those preferred shareholders. The remaining net income would be the return to common shareholders. So the return on common equity would be: $$\displaystyle \text{return on common equity} = \frac{\text{net income - preferred dividends}}{\text{average common equity}}$$

Incorrect. The return to common shareholders would not include the equity put into the company by preferred shareholders.

In summary: [[summary]]

When reviewing material used to evaluate companies for investment, you will likely have to calculate return on assets (ROA). The calculation is $$\displaystyle \textrm{ROA}=\frac{\textrm{net income}}{\textrm{average total assets}}$$, where average total assets is over the time period that matches the net income figure. A higher level of income will raise the calculation, as will putting the same income over fewer average assets. A larger ROA indicates a firm is doing a better job at using its assets to create income.

A higher number on either of these measures of return on equity would be good for all shareholders of USA Motors stock.

USA Motors

Autocar

Subtract the after-tax interest expense from net income

Add the after-tax interest expense back into net income.

Less

Greater

Net income plus preferred dividends

Net income minus preferred dividends

Net income plus preferred stock equity

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