Return on Equity (ROE):
• It is the ratio that shows the proportion of profit in comparison with
the net assets it holds.
• It is useful for the performance comparison of similar firms/companies
in terms of money.
• It is the ratio of Net Income by Common shareholder’s equity
Figure 1: Formula of ROE
ROE = Net Income / Common shareholder’s equity
Importance of ROE:
• It directly impacts stock valuation
• Higher the ROE, higher the real value of the company
• ROE can be applied to any organization or product
• ROE is, simply, that it is not asset dependent.
Limitation of ROE:
• If the rate of depreciation is higher than it will lead the higher rate
of depreciation leads to a lower net income and in turn lowers the ROE.
• Net income of an organization may be manipulated by top-level
management.
• It shows the percentage scenario rather than the real amount.
Return on Assets (ROA):
• It is a ratio that shows the profitability of any organization by the
utilization of assets.
• It provides the ratio showing, how much profit the can organization
produce from its assets.
• It shows the capital strength of an organization.
Figure 2: Formula of ROA
ROA = Net Income / Average Total Assets
Importance of ROA:
• It is important to know the organization’s capacity
• It is important to compare the capacity of the same kind of
organization.
• It is important for management to know their current utilization of
assets compared to their
previous year’s assets utilization
• If the ROA is lower then it shows the weak performance of a higher level
of management.
Limitation of ROA:
• It does not show the scenario for liabilities.
• It does not consider the capital borrowed(loan) from another source.
• It is not useful for the organization having large investment and
service-based organizations.
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Thanks for the article.
Very useful information.