Return on investment (ROI) and return on asset (ROA) are both common metrics used in personal and business accounting. You’ll find both metrics on income statements and other financial statements. While both ROI and ROA help measure a company’s performance, they have multiple key differences. The difference between both is in what they measure. ROI expresses the return on a financial investment, while ROA measures how effectively a business uses its total or average assets. And both are commonly used to measure a company’s efficiency.
What is Return on Investment (ROI)
ROI expresses the profit of a specific investment as a percentage of the investment expense. The ROI formula is to divide the profit by investment expense and multiply by 100. For example, you could invest $1,000 in stocks and make $500 in profit. Your ROI would be 50%.
Note that ROI does not express how much profit you’ve made in absolute terms. It’s only a percentage. ROI is useful for both personal finance and business decision making.
Why is ROI important for businesses
ROI helps evaluate the profitability of an investment expense. Large and small businesses use ROI for different types of investments, ranging from capital intensive business assets to hiring new employees. A business can use ROI to calculate the return on these investments.
ROI is the most common metric to calculate return because of its simplicity. The ROI formula is simple and easy to interpret. A positive ROI means that a specific investment will generate profits. You can show a positive ROI to your investors to justify a specific investment.
For example, let’s say Joe is the CEO of a manufacturing company that makes beds. He wants to make a capital intensive investment in a new manufacturing machine. The machine costs $5000. But Joe estimates it would generate a net profit of $1,000. Using the ROI formula, we get a positive return on investment of 20%.
But what if, instead, Joe invests this money in a digital marketing campaign that costs $5,000 but gives $2,000 in net profit? The ROI for this investment is a positive 40%. Assuming Joe only has $5000 to invest, the ROI suggests he should choose the digital marketing campaign.
The above example illustrates how businesses also use ROI to compare investments. Managers use ROI to determine how a company earns the most profit. A manager’s goal is for the invested capital to provide the most returns.
What is Return on Assets (ROA)
Return on Assets (ROA) expresses a company’s profitability as a ratio of its total income to total assets. So the ROA formula is to divide a company’s net income by its total assets. ROA can be expressed as both a ratio and a percentage. You can find net income by subtracting costs from revenue.
Investors, corporate leaders, and analysts use ROA to judge the profitability of different companies in different industries. A higher ROA means a company efficiently manages its balance sheet to generate company profits. Conversely, a falling ROA means a company has room for improvement.
Why is ROA important for business?
ROA helps business leaders measure performance by evaluating the return on a company’s assets. Comparing income to a company’s total assets reveals the feasibility of a company’s existence. ROA is the simplest measure of a company’s performance because it reveals what a company’s earning with what it has.
That being said, the ROA for different companies varies massively across different industries. The ROA for a private manufacturing company won’t be the same as the ROA for a public tech firm. So the best way to use a company’s ROA is to measure changes in it over a given period.
The ROA figure tells investors how good the company is at generating profits with its current asset base. An increasing ROA means the company is improving productivity. Investors prefer companies with higher ROAs because they generate more company income with a smaller investment.
ROI and ROA Calculations
A company’s return on assets and return on investment ratios belong to its financial statements. And both ROA and ROI are used to evaluate a company’s financial performance.
ROA
One of the key differences between ROA and ROI is how they’re calculated. ROI is usually calculated before subtracting total debt, while ROA accounts for a company’s debt.
Return on assets calculation is done by dividing a company’s net income by its average assets:
ROA=Net income/average assets
ROI
Return on investment is calculated by dividing the gains from a financial investment by its investment expense.
There are two ROI formulas:
ROI= (Cost of Investment/Net Return on Investment) × 100%ROI= ((Final value of investment−Initial investment)/Cost of Investment) ×100%
Limitation of ROA Analysis
Limitation of ROA Analysis
ROA can’t be used across different industries because different industries have different asset bases. For example, a steel manufacturing company will always have a higher ROA figure than a similarly performing retail store.
More useful for the financial industry
Some financial analysts believe the ROA formula is only suitable for financial institutions like banks. A bank’s balance sheet represents the real value of its total assets and liabilities since they’re stated at market value. Banks include interest income and income expense in their financial accounting.
ROA Does Not Explain Its Increase or Decrease
The ROA formula uses historical data. So it only measures current performance and can’t be used by equity investors to make future projections. You can’t use ROA to tell if your invested capital in a business will generate profits in the long term.
ROA also uses net income rather than operating income. So it’s possible for an unrelated increase in operating income to reduce one company’s ROA rather than the company becoming more inefficient.
Differences in Accounting methods
You can meaningfully compare the ROIs of different companies when they use the same accounting methods. You can’t meaningfully compare the ROI of three companies if the first uses historical costs of assets, the second uses average total assets, and the third uses current cost of assets.
ROA doesn’t tell which assets are not efficient
A company’s ROA only tells how efficiently it uses its assets. It does not indicate how the assets are used to generate income. Some assets could disproportionately generate revenue than others, but the ROA figure would not express that.
The ROA for an asset intensive company differs markedly from an asset light company.
Limitations of ROI Analysis
The exact parameters for ROI analysis are hard to define
The terms’ profit’ and ‘investment’ have diverse meanings. The profit in an ROI formula could be profit after tax, profit before interest expense, or profit after tax and interest expense. The tax rate applied to income from a financial investment could heavily impact its ROI.
One company could use net operating profit to calculate profit, while another might also deduct interest and taxes. You wouldn’t be able to meaningfully compare the ROI for the two companies.
Similarly, investment could be defined as gross book value, current cost of assets, historical cost of assets, or average total assets. Different companies use different definitions for invested capital.
High ROI doesn’t mean high value business
Making high ROI investments does not guarantee the highest increase in a business’s value. If a manager consistently invested in high ROI areas, they could ignore investments that would increase a business’s value despite a lower ROI.
The result would be a sub-optimal allocation of resources.
ROI doesn’t provide a holistic picture in long term planning
ROI focuses on short term results instead of long term profitability. The ROI formula only uses revenue and cost figures for a given period. Those costs and figures could either rise or decline long term, massively impacting a business’s net income and profitability long term.
A business might not increase its total value in the most efficient way by prioritizing return on investment (ROI).
What is a good ROI and ROA
ROI
Most financial professionals believe a 10.5% ROI for investments in stocks to be desirable, but a 20% ROI figure is considered excellent. The standard for a good ROI figure varies drastically across different industries.
ROA
Most financial professionals consider 5% to be a good ROA and a ROA over 20% to be excellent. Again you can only meaningfully compare ROA figures in the same industry or for the same company.
What is the difference between ROI and ROE?
Return on equity (ROE) and return on investment (ROI) are both financial ratios used to measure a company’s financial performance. Each ratio provides a different perspective on a company’s financial health.
ROE measures how effectively a company manages the money invested in it by investors and shareholders. So it’s related to the internal financial management of a company.
ROI measures the profitability of an investment for a company in terms of the initial investment. It’s used for comparing companies and deciding whether a company should make a particular investment.
You would use an ROE to compare a company with its competitors to determine whether it’s successful. And you’d use an ROI to understand how effectively a company allocates its resources.
Which is better: ROA or ROE?
Return on Equity (ROE) is a company’s net income divided by shareholder’s equity. It’s often calculated with average equity over a given period due to a mismatch in a company’s income statement and their balance sheet.
One of the key differences between return on equity(ROE) and return on assets (ROA) is how the company’s debt is taken into account. Without debt, a company’s shareholder’s equity equals its total assets. Therefore its return on assets(ROA) and return on equity would also be equal.
But that’s no longer true if a company takes on financial leverage, which would increase its assets in the form of cash. As such, a company’s ROA falls while its ROE stays constant when it takes on financial leverage.
So whether return on assets (ROA) or return on equity (ROE) is better for analyzing a company’s performance depends on context. Either metric could be more relevant than the other. Ideally, you should measure a company’s financial performance with both ROA and ROE in context with other information in financial statements.
Hopefully, you will have found this article helpful in better understanding both personal and business finance.
Author: Ramish Kamal Syed | Editor: Syed Hamza Ali | SEO Editor: Muhammad Waqas Aslam