Return on equity (ROE) measures how well a company does earning money for its investors. As a financial report reader, you'll probably find it easier to determine an ROE for a company than an ROA. Although the ROE is an excellent measure of how profitable the company is in comparison with other companies, you want to examine the ROA also because that ratio looks at returns for investors and creditors.
How to calculate ROE
You calculate ROE by dividing net income the company earned (which you find at the bottom of the income statement) by the total shareholders’ equity (which you find at the bottom of the equity section of the balance sheet):
Net income ÷ Shareholders’ equity = Return on equity
You can figure out Mattel's ROE based on its 2012 income statements and balance sheets:
$776,464,000 (Net income) ÷ $3,067,044 (Shareholders’ equity) = 25.3% (ROE)
Mattel made 26 percent on each dollar of shareholders’ equity. Following is Hasbro's ROE, also based on 2012 income statements and balance sheets:
$335,999,000 (Net income) ÷ $1,507,379 (Shareholders’ equity) = 22.3% (ROE)
Hasbro made 22.3 percent on each dollar of assets. Comparing Mattel and Hasbro, you can see that Mattel generated more than Hasbro on its shareholders’ equity. It's another reason investors pay more for Mattel stock.
How to react to companies with ROEs assistance
Investors most often cite the ROE ratio when they want to see how well a company is doing for them. Looking at that ratio can be a huge mistake because ROE ignores the impact of debt on profitability and thus doesn't give investors the full picture of a company's financial position. ROE doesn't consider the impact of a company's debt position on its future earnings potential.
Comparing ROE to ROA for Mattel and Hasbro, you can see that both companies’ ROEs look better than their ROAs:
| ROA | ROE | |
|---|---|---|
| Mattel | 11.9% | 25.3% |
| Hasbro | 7.8% | 22.3% |
The primary reason ROE often looks better than ROA is that ROE doesn't include debt.
When you see comparisons of company statistics, you frequently find an ROE but see no mention of an ROA. Many companies believe that ROA is primarily a statistic to be used by management and the company's debtors.
Take the extra time to determine the company's ROA and compare it with the ROA of other firms in the industry. You get a much better idea of how well the company generates its profit when you take both debt and equity into consideration.