Return On Invested Capital versus Return On Equity versus Return On Assets
versus Return On Investment. Why do we need them,
and what are the similarities and differences between
these financial metrics? Let’s start with the common factor in these
financial metrics. ROIC, ROE, ROA, ROI. Do you see any similarities? Yep! They all start
with R O which means Return On, which is then followed by one or more letters of the alphabet.
Each of these financial metrics is trying to help you understand how much bang for the
buck you get, in more financial terms how much value for money you get. For all of these
financial metrics (ROIC, ROE, ROA, ROI), the higher the better, assuming the returns are
sustainable and not a one-off. That’s because the formula, the calculation
of the financial metrics, is very similar. Put the bang in the numerator, and put the
buck in the denominator. In other words, put the outputs or benefits or returns (per year)
in the numerator, and the inputs or investment or capital in the denominator. If I invest
$1, how much annual return is being generated on that investment.
Let’s look at the formula more specifically for each of the four common financial metrics.
ROIC, Return On Invested Capital, is calculated as the sum of after-tax interest expense plus
net income, divided by the sum of debt plus equity. ROE, Return On Equity, is calculated
as net income divided by equity. ROA, Return On Assets, is calculated as net income divided
by assets. ROI, Return On Investment, is calculated as benefits or returns divided by investment.
Let’s make some meaningful comparisons on a one-to-one basis
between these financial metrics.
In the blue corner: ROIC. In the red corner: ROE.
What is the difference between Return On Invested Capital and Return On Equity?
In my view, this is the broader perspective of ROIC focusing on the returns for both bondholders
and shareholders (in other words “debt and equity” or “invested capital”), versus
the narrower perspective of ROE focusing specifically on the returns for shareholders.
In the blue corner: ROA. In the red corner: ROE. The similarity between Return On Assets
and Return On Equity is that both financial metrics have net income in the numerator.
The difference between ROA and ROE is in the denominator: Assets versus Equity. Let’s
look at the balance sheet. Assets is the sum of what a company owns, bottom left of the
balance sheet. Equity is the book value of the shareholder capital, a subset of what
a company owes on the right hand side of the balance sheet. As liabilities are by definition
greater than or equal to zero, and in actuality for most companies a sizable number, equity
should be a lower number than assets. Therefore, if the denominator number is lower, then Return
On Equity should be higher than Return On Assets. ROA and ROE are related metrics in
the DuPont formula. ROE equals ROA times leverage.
In the blue corner: ROA. In the red corner: ROI.
Return On Assets and Return On Investment are similar, but I would use them in very
different situations. I use Return On Assets when analyzing the financial statements of
a company in an annual report, while I use Return On Investment when analyzing a specific
investment like a machine or a piece of software, or the expected return on bonds or stocks.
An example of ROI: when buying a new machine for $100K, how much incremental margin will
the product produced on that machine generate for the company?
In the blue corner: ROE. In the red corner: ROI. These can both be used on the project
or deal level. Return On Equity for the expected or actual benefits purely for the shareholder
in the project or deal. Return On Investment for the overall benefits of the project, regardless
of its financing structure. As borrowing money through debt tends to be at a lower cost than
the desired returns by shareholders, ROE on a project or deal is usually higher than ROI.
In summary: ROIC, ROE, ROA and ROI are similar metrics, helping you to analyze whether an
investment brings value for money. You can choose which financial metric to use for a
specific situation. Each metric has a situation where it provides the most relevant perspective.
Remember, financial analysis is as much an art as it is a science!
I hope this explanation and discussion of ROIC versus ROE versus ROA versus ROI was
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