How To Determine Management Effectiveness

Investors and traders both use alot of ratios to deduce whether to buy/sell/short a security. With so many ratios to consider, it can get confusing, especially when 2 ratios almost look alike.

Consider return on equity (ROE) and return on assets (ROA). At first glance they do look similar. Both measure some kind of return and is some way are related to the company’s earnings from their investments. Obviously both ratios represent different things. A closer look at these two ratios reveals some key differences. Let us find out more.

Return on equity (ROE)
Of all the fundamental ratios that investors look at, one of the most important is return on equity. ROE is nothing but a measure of how much profit a company generates with the money shareholders have invested. In other words how effectively the company uses the money invested by investors. This tells you alot about how good the management of the company is.

Return on Equity = (Annual Net Income/Average Shareholders’ Equity)

The net income can be found out from the income statement, and the average shareholder’s equity from the balance sheet.

Example on ROE
Lets take an example of a fictional company Weird Inc. Say they had a net income of $5 billion in 2006, and their stockholder equity was $10 billion in 2005 and $30 billion in 2006. To calculate ROE, average shareholders’ equity for 2005 and 2006 ($10 billion + $30 billion$ / 2) is $20 billion. Dividing net income for 2006 by the average shareholder’s equity gives us the return on equity (ROE) of 0.25 or 25%. What this tells us is that in 2006 Weird Inc generated a 25% profit on every dollar invested by investors. Generally savvy investors look for a ROE of at least 15%, so in our example Weird Inc’s performance is impressive. Weird Inc’s management was able to acheive higher profits from the investor money, which speaks of an effective management.

Return on asset (ROA)
So now that we understand what ROE is, lets focus on ROA. ROA is nothing but a measure of how much profit a company earns for every dollar of its assets. Again this reveals how effective the company management is. Assets include things like cash in the bank, accounts receivable, property, equipment, inventory and furniture.

Return on Assets = (Annual Net Income/Total Assets)

Example on ROA
Lets look at Weird Inc again. You already know their net income was $5 billion in 2006. Say their total assets amounted to $200 billion. The net income divided by total assets gives a return on assets of 0.025 or 2.50%. This tells us that in 2006 Weird Inc earned 2.5% profit on the resources it owned. This is an extremely low number. In other words, Weird Inc’s ROA tells a very different story about the company’s performance than its ROE. Few professional money managers will consider stocks with an ROA of less than 5%.

A Look At Debt
The important factor that separates ROE and ROA is debt. Accounting 101 tells us, Assets = Liabilities + Shareholder’s Equity. Say if a company carried no debt (ie. Liability = 0), its shareholders’ equity and its total assets would be the same. It follows then that their ROE and ROA would also be the same. Now say the company took a debt to fund a certain project. What would happen to ROE and ROA ? By taking on a debt, the company increases its assets due to cash coming in. However that would reduce the company’s equity. With reduction in equity, ROE will rise. At the same time, when a company takes on debt, the total assets increases which makes ROA rise too. However ROE would rise above ROA giving us a good indication of the debt levels of the company. Warning: Because ROE weighs net income only against owners’ equity, it doesn’t say much about how well a company uses its financing from borrowing and bonds. Such a company may deliver an impressive ROE without actually being more effective at using the shareholders’ equity to grow the company. ROA because it includes both debt and equity can help you see how well a company puts both these forms of financing to use.

Going back to Weird Inc’s example we can see there is huge difference between its ROE and ROA, indicating an enormous amount of debt, which kept its assets high while reducing shareholders’ equity. In 2006, Weird Inc would have total liabilities of $200bn – $30bn = $170 billion more than 5 times its total shareholders’ equity of $30 billion.

Conclusion: Before trading in a stock, always keep an eye on the ROE and ROA. They are different, but together they provide a clear picture of management effectiveness. If ROA is sound and debt levels are reasonable, a strong ROE is a solid signal that the company is doing a good job of generating returns from shareholders’ investments. ROE is certainly a hint that management is giving shareholders more for their money. On the other hand, if ROA is low or the company is carrying a lot of debt, a high ROE can give investors a false impression about the company’s fortunes.