In around two minutes you will know what are the differences between ROA and ROE. You will get both professional definition and easy explanation. No intro, no outro, straight to the point.

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The main difference between Return on Assets and Return on Equity is which kind of profitability these ratios attempt to measure. Other differences would be different formulas and what these metrics can tell you about the leverage of a company.

And if you want to know what Return on Assets or Return on Equity mean individually, feel free to watch my previous videos.

Both ROA and ROE are profitability ratios. They even both use net income as a numerator in their formulas. But there are some significant differences between them two.

The first difference is what kind of profitability these ratios attempt to measure.

Return on Assets measures the profitability of a business by looking at how effectively the management of a company uses its assets. Such as machinery, equipment, and labor. For example, if ROA equals 15%, it means that this company was able to produce 15 cents of net income on each dollar of assets.

While Return on Equity measures the profitability of a business by looking at how effectively the management of a company uses its equity. Specifically, initial investors’ money and retained earnings. And, for example, if ROE equals 20%, it means that this company was able to produce 20 cents of net income on each dollar of equity.

The second difference is what these ratios use as denominators in their formulas.

Return on Assets formula is net income divided by total assets.

And return on equity formula is net income divided by total equity.

Pretty self-explanatory.

And the third difference is how the combination of these two ratios tells you whether a company is leveraged or not.

If ROE is more or less close to ROA, it most likely means that this company is not that leveraged. Meaning that equity capital (capital that a company owns) exceeds debt capital (capital that a company must eventually pay back).

But if ROE is much higher than ROA, it means that this company has too much debt capital. Which is mostly not good, because managing such debt can be difficult.

Here is much easier example.

Company A has $1 million in assets, $200,000 in liabilities, and $800,000 in equity. Its net income is $200,000. ROA is $200,000 divided by $1 million, which equals 20%. And ROE is $200,000 divided by $800,000 which equals 25%. Both ROA and ROE are more or less close, and as you can see, this company doesn’t have that much liabilities.

Company B has the same $1 million in assets, $900,000 in liabilities, and $100,000 in equity. Its net income is $200,000. ROA is $200,000 divided by $1 million, which equals 20%. But ROE is $200,000 divided by $100,000, which equals 200%. Much bigger difference between ROA and ROE.

Many would say that this company is outstanding, because it was able to produce 200% return on equity. But what these people forget is that it has 9 times more liabilities than equity. Meaning that this company is heavily leveraged. And, as mentioned previously, such high level of debt can be very hard to manage for a long period of time.

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*None of this is meant to be construed as investment advice, it's for entertainment purposes only. Links above include affiliate commission or referrals. I'm part of an affiliate network and I receive compensation from partnering websites. The video is accurate as of the posting date but may not be accurate in the future.

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