Jaime is a Credit Officer of a Financial Institution and has to evaluate the profitability of one of his clients' business. You are aware that there are two important ratios: ROA (Return on Assets) and ROE (Return on Equity), but you do not know the relevance of each.
Researching the web, he finds that for many, ROA is more important, "because it isolates the effect of leverage." Intrigued, he decides to contrast that with the financial information of his different clients and chooses two companies in the same sector with a similar economic-financial structure:
LEVERAGE SAC and PATRIMONIO SAC. After the rigorous calculation of the different ratios and inquiries of the character of the owners, he finds that:
APALANCAMIENTOS SAC has an ROE of 25.00% and an ROA of 5.00% and its majority shareholder, Mr. José Terceros is convinced that the business must be financed primarily with money from banks and suppliers; and, marginally, with contributions from partners. As a result of this policy, most of the assets of Leveraging SAC were financed through third parties. Situation reflected in the current debt ratio of the company, amounting to 4 times its equity.
PATRIMONIOS SAC has an ROE of 10.00% and an ROA of 6.25% and its main partner, Mr. Juan Seguro is a person who likes to move slowly but steadily, he is not very fond of debt and prefers to grow with his own resources. As a result of his way of thinking, only 37.50% of Patrimonios SAC's assets were financed through third parties and its indebtedness ratio amounts to 0.6 times equity.
After a first evaluation, Jaime asks himself:
Which of the two companies will be better for a Financial Institution? Leverage SAC or Patrimonios SAC ?.
Definitely the one with the least risk! - is answered.
Then he asks again:
Will ROE be useful to determine that?
Let's see! - He says:
In the case of Leveraging SAC, if I analyze only the ROE, I will ignore that the debt ratio amounts to 4 times, because the company prefers third-party financing, rather than the increase in equity. Therefore, the indebtedness being proportionally much higher than the equity, its ROE will always be high; While I do analyze ROA, I will only take into account the return on assets, which does not depend on the debt structure of the company.
Which then is more relevant?
Let's see the case of Patrimonios SAC! - he continued.
The ROE of the company is only 10%, but the indebtedness of only 0.6 times the equity; while the ROA is higher than that of Leveraging SAC.
Which profitability is more relevant, then? ROA or ROE?
My answer to Jaime's doubts would be that we must always choose as a tool for analyzing the profitability of a company, the ROA and not the ROE; since the latter ignores the debt ratio, which is a measure of the company's risk (the higher the debt, the higher the probability of default); while the ROA focuses on the profitability of the company's assets, which is indistinct from the sources of financing.
