Two Measures of the Same Profit

Return on assets equals net income divided by total assets. It shows how much profit a company generates from everything it owns, however those assets were paid for.

Return on equity equals net income divided by shareholders’ equity. It shows how much profit the company generates from the money its owners have invested, which is why shareholders often watch it closely.

The gap between the two comes from debt. For the full route from the exam to a career analysing companies for clients, our complete guide to how to become an investment adviser representative covers every step.

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What Return on Assets Shows

Return on assets measures how efficiently management turns the company’s resources into profit. A higher figure means each dollar of assets, whether factories, inventory, receivables or cash, is producing more earnings.

Because total assets are funded by both creditors and shareholders, ROA is not affected directly by how the company chooses to finance itself. That makes it useful for comparing companies with very different levels of debt.

Analysts often divide by average total assets for the year rather than the year-end figure, so that a large purchase or sale late in the year does not distort the result. The Series 65 Exam Preparation course at FRC covers both versions and when each is used.

What Return on Equity Shows

Return on equity measures the profit generated for shareholders on the capital they own. It answers the question an owner cares about most: how hard is my money working?

ROE is affected by financing choices. A company that borrows more, and therefore has less equity relative to its assets, will report a higher ROE from the same profit, as long as the borrowing earns more than it costs.

That makes a high ROE attractive but not always reassuring. An adviser needs to know whether it comes from a genuinely profitable business or from heavy use of debt.

Return on Assets and Return on Equity Compared

Worked Example: Calculating Both

A company earns net income of $60 million. Its total assets were $1,100 million at the start of the year and $1,300 million at the end, and shareholders’ equity averaged $400 million.

Step one: average total assets are $1,100 million plus $1,300 million, divided by 2, or $1,200 million. Step two: ROA is $60 million divided by $1,200 million, or 5 percent.

Step three: ROE is $60 million divided by $400 million, or 15 percent. The company earns three times as much relative to its owners’ capital as it does relative to its total assets, because only a third of those assets are funded by equity.

How Leverage Links the Two

The link between ROA and ROE is the equity multiplier, total assets divided by shareholders’ equity. ROE equals ROA multiplied by the equity multiplier.

In the example, the equity multiplier is $1,200 million divided by $400 million, or 3. Multiplying the 5 percent ROA by 3 gives the 15 percent ROE.

A company with no debt has an equity multiplier of 1, so its ROA and ROE are the same. The more a company relies on borrowed money, the larger the multiplier and the wider the gap between the two measures, a balance sheet question explored in our comparison of solvency vs liquidity.

Study Financial Ratios With FRC

Profitability ratio questions on the exam usually ask you to calculate ROA or ROE, identify which one is affected by leverage or explain why two companies with the same profit show different returns. Our Series 65 course works through each formula with numbers until the relationships feel natural.

Consider studying with FRC for every exam on your route. Explore our USA exam courses, from the SIE through the Series 7, Series 63 and Series 65.

To take advantage of the membership, explore FRC Professional Membership, which gives you a verified Digital Profile that shows employers your real-time course progress, together with the Video Resume. Current offers are on our membership deals page.

Same ROA, Very Different ROE: Worked Example

Company A and Company B each have total assets of $1,000 million and each earns an ROA of 6 percent, or $60 million. Company A is funded with $800 million of equity, while Company B is funded with only $250 million of equity and borrows the rest.

Step one: Company A’s equity multiplier is 1,000 divided by 800, or 1.25, so its ROE is 6 percent times 1.25, or 7.5 percent. Step two: Company B’s equity multiplier is 1,000 divided by 250, or 4, so its ROE is 6 percent times 4, or 24 percent.

Both businesses are equally efficient at using their assets. Company B’s far higher ROE comes entirely from its financing, and with it comes far more risk.

Leverage Works in Both Directions

Debt magnifies losses as well as gains. Suppose a downturn pushes both companies’ ROA to negative 2 percent.

Step one: Company A’s ROE becomes negative 2 percent times 1.25, or negative 2.5 percent. Step two: Company B’s ROE becomes negative 2 percent times 4, or negative 8 percent.

Company B’s shareholders suffer a loss more than three times as large as Company A’s, relative to their capital. Its lenders still expect their interest and principal, so a prolonged downturn could threaten the company’s survival.

Breaking ROE Into Three Parts

The DuPont analysis splits ROE into three drivers: net profit margin, asset turnover and the equity multiplier. Net profit margin is net income divided by revenue, and asset turnover is revenue divided by total assets.

Worked example: the first company has revenue of $800 million. Step one: net profit margin is $60 million divided by $800 million, or 7.5 percent. Step two: asset turnover is $800 million divided by $1,200 million, or about 0.667. Step three: multiplying 7.5 percent by 0.667 gives the 5 percent ROA, and multiplying by the equity multiplier of 3 gives the 15 percent ROE.

The breakdown shows where returns come from. A retailer may earn thin margins but turn its assets over quickly, while a software company may earn high margins on a smaller asset base, and both can reach similar ROE by different routes.

How Buybacks Can Raise ROE

Share buybacks reduce shareholders’ equity, which can raise ROE even when the underlying business has not improved. When the buyback is funded with debt, ROA can actually fall at the same time.

Worked example: the first company borrows $100 million at 6 percent to buy back shares, cutting equity from $400 million to $300 million while total assets stay at $1,200 million. Step one: interest is $6 million a year, or about $4.74 million after a 21 percent tax rate, so net income falls to about $55.26 million.

Step two: ROE rises to $55.26 million divided by $300 million, or about 18.4 percent, while ROA falls to $55.26 million divided by $1,200 million, or about 4.6 percent. Shareholders see a higher return on paper, but the company is less profitable relative to its assets and carries more debt.

Comparing Across Industries

ROA varies widely between industries because some businesses need far more assets than others. Banks hold large balance sheets of loans and securities, so their ROA is often around 1 percent, while asset-light businesses such as software or consulting firms can report much higher figures.

ROE varies too, partly because industries use different levels of leverage. Comparing a bank’s ROE with a technology company’s tells you little; comparing it with other banks is far more useful.

Advisers therefore compare a company with its peers and with its own history. A steady or rising ROA alongside a stable equity multiplier suggests genuine improvement, while a rising ROE driven only by a growing equity multiplier calls for a closer look at the balance sheet.

Where the Figures Come From

Net income comes from the income statement, while total assets and shareholders’ equity come from the balance sheet. Our comparison of income statement vs balance sheet explains where each figure sits and how the statements connect.

Because net income covers a whole year and the balance sheet shows a single date, using averages of the opening and closing balance sheet figures gives a fairer result. This matters most for companies that are growing quickly or have made large acquisitions.

One-off items can distort both ratios. A large gain from selling a division, or a big write-down, can push net income far above or below its normal level, so analysts often adjust for these before comparing years.

ROE and How Fast a Company Can Grow

ROE also feeds into how quickly a company can grow without raising new capital or adding leverage. The sustainable growth rate equals ROE multiplied by the retention ratio, the share of earnings the company keeps rather than paying out as dividends.

Worked example: the first company has an ROE of 15 percent and pays out 40 percent of its earnings as dividends. Step one: the retention ratio is 100 percent minus 40 percent, or 60 percent. Step two: the sustainable growth rate is 15 percent times 60 percent, or 9 percent a year.

This helps advisers judge whether a company’s growth plans look realistic. A company aiming to grow 20 percent a year with a sustainable rate of 9 percent will need to borrow more, issue shares or cut its dividend, each of which affects existing investors.

How Lenders Read the Two Ratios

Lenders and bondholders tend to focus on ROA rather than ROE. They are paid from the earnings the whole asset base produces, so a healthy ROA suggests the business generates enough to service its debt.

A rising ROE with a falling ROA is a warning sign for creditors. It usually means the company is taking on more debt while earning less on its assets, which reduces the cushion protecting lenders. Rating agencies watch for exactly this pattern when reviewing a company’s credit.

When ROE Stops Being Useful

ROE breaks down when shareholders’ equity is very small or negative. A company that has bought back large amounts of stock or built up losses can report an enormous ROE, or one that cannot be calculated meaningfully at all.

In those cases, ROA and measures such as return on invested capital, which includes both debt and equity, give a clearer view. Advisers do not rely on a single ratio, especially one that can be engineered by financing decisions.

Exam questions sometimes present a company with an unusually high ROE and ask what might explain it. High leverage and share buybacks are the usual answers, alongside genuine profitability.

The Memory Aid

Remember “assets for efficiency, equity for owners”: ROA measures how well all assets are used, ROE measures the return on shareholders’ money.

For the link, remember “ROE equals ROA times leverage”: multiply ROA by total assets divided by equity.

For DuPont, remember “margin, turnover, multiplier”: the three drivers multiply together to give ROE.

Exam Traps to Avoid

The first trap is assuming a higher ROE always means a better company. It may simply reflect more debt, which also increases risk.

The second trap is forgetting that a company with no debt has equal ROA and ROE. Any difference between the two comes from leverage.

The third trap is dividing by the wrong denominator. ROA uses total assets and ROE uses shareholders’ equity, not total liabilities or market value. The fourth trap is overlooking buybacks, which can raise ROE by shrinking equity without improving the business.

A Client Scenario

A client wants to buy shares in a company because a stock screen shows its ROE of 30 percent, far above its competitors. He assumes it must be the best-run business in its industry.

The adviser checks the ratios and finds the company’s ROA is 4 percent, slightly below its peers, and its equity multiplier is 7.5 after years of debt-funded buybacks. The high ROE comes mainly from leverage rather than superior operations.

The adviser explains that the company’s returns would fall sharply in a downturn and that its heavy debt adds credit risk. The client decides to compare it with a competitor that has a lower ROE but a higher ROA and less debt, and the adviser records the analysis in the file.

The Dictionary as a Video Library

The FRC dictionary is a study tool, not just a glossary. Every entry pairs a written explanation with deep-dive video, on-page quizzes and interactive flash cards, so you can read a concept, watch it explained and test yourself in one place.

Rules are covered in the same depth: open a rule and you will find the full explanation alongside video walk-throughs of how it applies in practice. Open the return on assets and return on equity entries to see each formula and the DuPont breakdown explained on video and test yourself with the quizzes.

Practice Questions to Test Yourself

Question one: Net income is $30 million and total assets are $600 million. What is ROA? 5 percent.

Question two: The same company has shareholders’ equity of $200 million. What is ROE? 15 percent.

Question three: A company’s ROA is 4 percent and its equity multiplier is 2.5. What is its ROE? 10 percent.

Question four: A company has no debt and an ROA of 8 percent. What is its ROE? 8 percent, because its assets equal its equity.

Question five: Net profit margin is 10 percent, asset turnover is 0.5 and the equity multiplier is 2. What is ROE? 10 percent times 0.5 times 2, or 10 percent.

Turn Financial Analysis Into Career Evidence

Clients often bring an adviser a single impressive number from a screen or a headline, and showing them what lies behind it builds lasting trust. FRC’s Digital Profile shows employers the courses you are actively studying and the progress you have earned through assessed learning, verified by FRC, and a QR code on your resume takes them straight to it.

The FRC Video Resume lets a hiring manager hear you before the interview. Explaining how debt can turn a modest ROA into a striking ROE shows the analytical judgment advisory firms look for.

Related Questions

Heavy leverage that inflates ROE also raises credit risk, which can push a company’s bonds from one rating category to another, as our comparison of investment grade vs high yield bonds explains.

Key Points to Retain

Return on assets equals net income divided by total assets and measures how efficiently a company uses everything it owns. Return on equity equals net income divided by shareholders’ equity and measures the return on the owners’ capital.

ROE equals ROA multiplied by the equity multiplier, so debt widens the gap between them and magnifies both gains and losses. Advisers check ROA, the equity multiplier and the DuPont drivers before trusting a high ROE, because leverage and buybacks can inflate it without improving the business.

For the role the exam leads to, read our guide to what an investment advisor representative is.