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But every company has equity. Again, you may wonder, is this good? Whether this is a positive or a negative depends on whether the first company is using its borrowed money judiciously. Most companies look at ROA and ROE in conjunction with a variety of other profitability measures such as gross margin or net margin.
Together those figures give you a general sense of the health of the company, especially in comparison with competitors. Often investors care about these ratios more than managers inside companies do. Similarly, banks will look at these figures to decide whether to loan money to a business.
Managers in some industries find ROA to be more useful in making decisions. For example, says Knight, a construction company might look at the ROA in comparison with its competitors and see that the rival is getting a better ROA even though they have a high profit margin.
Take our Car Company example again. This means that last year the company generated an extra 20 cents for every dollar put into it. The board can then choose to return some of that money to the shareholders who put those dollars into the company in the first place. Whatever it does not return to the shareholders the company will keep for reinvestment in its growth.
So we would calculate potential growth as a factor of retention against RoE:. DuPont chemical came up with a slightly more complicated way of assessing return on equity. Their formula is designed to help investors think about a company's profitability more clearly than the standard RoE formula allows for.
The DuPont formula calculates return on equity by comparing a firm's total profit margin against its sales turnover against its financial leverage. Here's the math:. While this formula generally produces the same result as the classic return on equity approach, it can help an investor break down a company's performance more clearly. It's important to be careful of abnormally high return on equity for a firm's size and character, as well as for sudden spikes in an individual company's return.
Both can be indicators of trouble. Recall that the denominator of the return on equity formula is shareholder equity, the comparison of a firm's assets to its liabilities. If a company quickly loses assets or takes on a lot of debt, its shareholder equity will fall. If sales and profits remain untroubled by this, the sudden drop in RoE denominator can cause the percentage to dramatically rise.
That doesn't necessarily mean the firm is in good health though. It might mean anything from uninspired corporate restructuring to crippling future debt problems. Under ordinary circumstances investors do not calculate a return on equity for firms with a negative net income, as in this case the return is zero.
However, it's possible for a firm to have negative shareholder equity due to liabilities exceeding assets at a time of positive net income returns.
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