Key Difference – ROA vs ROI
Investors always attempt to generate higher returns for their investments and frequently compare investment options and companies to invest in. Companies want to make higher profits with greater efficiency to be stabilized and create shareholder value. There are a number of investment appraisal options the investors and businesses can select to evaluate return generating possibilities. ROA and ROI are two vital measures that can be used in this exercise. ROA (Return On Assets) calculates how much income is generated as a proportion of assets while ROI (Return On Investment) measures the income generation as opposed to investment. This is the key difference between ROA and ROI.
CONTENTS
1. Overview and Key Difference
2. What is ROA
3. What is ROI
4. Side by Side Comparison – ROA vs ROI
5. Summary
What is ROA?
ROA (Return on Assets) demonstrates how profitable a company is relative to its total assets with the intention of making a profit. The higher the return, the more efficient the management is in utilizing its asset base. The ROA ratio is calculated by comparing the net income to average total assets, and is expressed as a percentage.
ROA = Net income / Average Total Assets
Net Income
Net income is the profit available for company’s shareholders after the tax payment. Thus, it is also referred to as Profit after Tax (PAT) or Net Earnings. In other words, this is the bottom line in the income statement.
Average Total Assets
Total assets comprise of current assets and noncurrent assets. An average is considered here instead of opening or closing assets to provide increased accuracy.
ROA is an important ratio to measure the effectiveness of the resource allocation of funds in the company. The decision makers must consider a wide range of investment options before investing and need to ensure that they are well aware of the associated costs and benefits. If more promising investments are made, the asset base can be put to effective use; thus, the resulting ROA will be higher.
ROA can be compared with the interest rate paid on debt. That is, if the company is generating a ROA higher than the interest paid on loans, this is a favorable situation. Similarly, ROA can also be compared against the company’s cost of capital (opportunity cost of investing in a project or a company) to understand whether the investment is worthwhile. Moreover, it’s important that investors ask how a company’s ROA is compared to those of its competitors and to the industry average.
Figure 1: ROA of companies in same industry can be compared to identify effectiveness of performance
Reasons for Lower ROA
Incompatible investments
Investing in projects that do not utilize the assets effectively results in lower ROA
Lower productivity in assets
Productivity is the yardstick of output per unit of input. Some assets may not be able to generate the intended output and this can be a result of assets being old, technically obsolete or improperly maintained. Such situations lead to lower productivity.
Wastage
Wastages in the form of raw materials, overheads, and product defects can result in a decreased ROA. Wastage can be reduced by adopting techniques such as lean production methods to eliminate nonvalue-adding activities
What is ROI?
ROI can be categorized as an important tool to derive the return from an investment. This formula is frequently used by investors to calculate how much return is received for a particular investment as a proportion of the originally invested amount. ROI is calculated in percentage form as per below.
ROI = (Gain from Investment – Cost of Investment)/ Cost of Investment
E.g. Investor K purchased equity shares of Company D for a value of $1000 2015. On 31.01.2017 shares are sold for a value of $ 1300 making a gain of $300. Thus the ROI can be calculated as,
ROI = (1000 – 300) / 1000 = 30%
ROI also assists in comparing returns from different investments; thus, an investor can select which one to invest if there are two or more options. Therefore, it serves as a very useful tool that should be considered before making investments.
Companies also calculate ROI as an indication of how well the capital invested is utilized to generate revenue.
ROI = Earnings Before Interest and Tax / Capital Employed
ROI can be measured as a whole for the company as well as for each profit generating unit (separate business units) in the case of a larger company. Such divisional ROIs can be used as a yardstick to measure the amount of profits contributed by each unit. Based on this, performance measures can be decided for each division as well.
What is the difference between ROA and ROI?
ROA vs ROI |
|
| ROA measures profitability against assets | ROI measures profitability against investment |
| Measure | |
| This is an efficiency ratio. | This is a profitability ratio. |
| Formula for Calculation | |
| ROA = Net income / Average Total Assets | ROI = Earnings Before Interest and Tax / Capital Employed |
Summary – ROA vs ROI
Although there is a difference between ROA and ROI, both are two key ratios that can be used to measure returns generated proportionate to assets and investments respectively. To better understand their usefulness they should be compared against ratios of past years and other companies in the same industry. While both are useful, it should also be noted that both ROA and ROI are heavily affected by the size of the asset/ investment base where if the asset/investment base is larger, the resulting ROA or ROI will be lower.
Reference:
1. “Return on Assets (ROA).” EFinanceManagement. N.p., 20 Dec. 2016. Web. 14 Feb. 2017.
2. “Return on Investment (ROI): Advantages and Disadvantages.” YourArticleLibrary.com: The Next Generation Library. N.p., 13 May 2015. Web. 14 Feb. 2017.
3. “Profitability Indicator Ratios: Return On Assets.” Investopedia. N.p., 29 May 2007. Web. 14 Feb. 2017.
4. “RETURN ON ASSETS (ROA).” Return on Assets (ROA) – percentage, benefits, cost, Uses for roa. N.p., n.d. Web. 14 Feb. 2017
Image Courtesy:
1. “Return on asset” By Alexeykob – Own work (CC BY-SA 3.0) via Commons Wikimedia