Return on Assets (ROA)

ROA vs. ROE: What is the Difference?

The relationship between return on assets (ROA) and return on equity (ROE) is directly related to the topic of debt financing, i.e. the reliance on leverage in the capital structure.

The difference between return on assets (ROA) and return on equity (ROE) is that the ROA metric does not factor in debt in a company’s capital structure.

For a company carrying no debt on its balance sheet – i.e. an all-equity firm – its shareholders’ equity and its total assets will be equivalent (and ROA and ROE would be equal).

But if those companies were to raise debt capital, their ROE would rise above their ROA from the increased cash balance, as total assets would rise while equity decreases.

Return on Assets Calculator (ROA) | Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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1. Balance Sheet Assumptions

For our modeling exercise, we’ll be assuming the following operating assumptions.

Balance Sheet Assumptions (Year 1)

• Cash & Cash Equivalents: $20m
• Accounts Receivables (A/R): $40m
• Inventories: $60m
• PP&E, net: $120m

Here, we’ll assess two different scenarios, which we can toggle between in the “Case” cell (L3).

1. Upside Case
2. Downside Case

With Year 1 as our starting point, we’ll assume the following year-over-year changes on the B/S.

Upside Case Assumptions

• Cash & Cash Equivalents: +$4m
• Accounts Receivables (A/R): $0m – No Change
• Inventories: –$2m
• PP&E, net: –$4m

If the active case is set to “Upside”, the “Total Current Assets” increases from $150m in Year 1 to $158m by the end of Year 5.

Under the same time horizon, the “Total Assets” balance decreases from $270m to $262m.

The takeaway is that the current asset balance is trending upward, but the cause of the positive +$8m change is caused by the cash balance increase, not inventories.

Regarding the fixed assets base (i.e. the PP&E), the decline of $16m implies fewer capital expenditures are required.

As for the other case, if we set the active case to “Downside” instead, the signs in the “Step” column are each flipped.

Downside Case Assumptions

• Cash & Cash Equivalents: –$4m
• Accounts Receivables (A/R): $0m – No Change
• Inventories: +$2m
• PP&E, net: +$4m

The net impact is the “Total Current Assets” declines from $150m in Year 1 to $142m in Year 5 – a total decrease of $8m.

For the “Total Assets” line item, the balance increases from $270m in Year 1 to $278m in Year 5.

The increase in PP&E sitting on the B/S can be interpreted as increased CapEx spending, which is often caused by lackluster growth and/or increased competition in the market.

2. Income Statement Forecast Build

In the next step, all that remains to complete our return on assets (ROA) calculations is the net income assumptions.

Income Statement Assumptions

• Net Income in Year 1 = $25m
• Upside Case YoY Change = +$2m
• Downside Case YoY Change = –$2m

Under the “Upside Case”, net income increases from $25m to $33m, whereas in the “Downside Case”, net income declines from $25m to $17m.

3. Return on Assets Calculation Example

In the next part of our exercise, we’ll divide the net income in each period by the average balance between the prior period and current period “Total Assets” balance, we can calculate the ROA for the projection period.

To reiterate from earlier, the equation for calculating the return on assets is shown below.

Return on Assets (ROA) = Net Income ÷ (Average Total Assets)
For the “Upside Case”, the company’s return on assets (ROA) increases from 10.0% to 12.5% – which implies more efficient resource allocation, causing increased net earnings.

For instance, the cash balance is increasing, which means the company has more liquidity on hand and fewer cash outflows related to inventory purchases and Capex.

The decline in inventory signifies faster inventory turnover from increased customer demand, and the declining PP&E means more value is being created by the existing fixed assets with minimal Capex spending requirements.

4. Return on Assets (ROA) Ratio Analysis

To reiterate from earlier, the higher a company’s ROA, the more operationally efficient management is at generating more profits with fewer investments (and vice versa).

However, in the “Downside Case”, the company’s return on assets (ROA) declines from 8.5% in Year 1 down to 6.1% – with the opposite changes (and implications) on the balance sheet and income statement.

In closing, the return on assets (ROA) metric is a practical method for investors to grasp a better understanding of how efficient a company is at converting its asset purchases into net income.