Understanding these two accounting concepts is useful in evaluating a company.
Many investors look to the amount of income a company is able to produce from given investment of resources as a measure of its fundamental strength. Calculating returns as a percentage of total assets is one common way for investors to evaluate companies, as is calculating a similar return as a percentage of the company’s shareholders’ equity. These two returns can be different, but by definition, the return on assets can never exceed the return on equity.
Two ways of understanding internal returns
Return on assets and return on equity are two different ways of expressing internal returns, and they’re both quite simple. The return on assets equals the net income from a company during a period divided by the average assets of the company over the same period. The return on equity is the company’s net income divided by its average shareholders’ equity.
The big difference between the two formulas is the measurement of assets versus shareholders’ equity. If you remember that shareholders’ equity is equal to total assets minus total liabilities, then it’s easy to understand why returns on assets will never exceed returns on equity.
Case 1: An unlevered company
First, consider a simple company that has assets but no liabilities. In this case, the value of shareholders’ equity will be equal to the asset value. Therefore, since the return on assets and the return on equity are both based on net income, then this company’s return on assets will be the same as its return on equity.
Case 2: A company with debt
By contrast, if a company does have outstanding liabilities, then you have a more complex situation. In this case, assets will always exceed shareholders’ equity by the amount of debt outstanding. Because the return calculations divide by assets or equity, the return on assets will be smaller than the return on equity when assets are greater than equity.
For example, say a company makes $100,000 with assets of $1,000,000 and debt of $500,000. In this case, return on assets equals $100,000 divided by $1,000,000, or 10%. However, the shareholders’ equity equals assets of $1,000,000 minus liabilities of $500,000, for a net of $500,000. That makes the return on equity $100,000 divided by $500,000, or 20%.
One caution, however, is not to assume that incurring debt will always raise return on equity. Taking out debt incurs interest expense, and if financing costs exceed the returns on additional assets, then net income will fall, potentially reducing returns on equity.
For the most part, the difference between return on assets and return on equity will give you an indication of how leveraged a company is. For those with little debt, the numbers will be very close to each other, but return on assets will never be greater than return on equity.
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