ROE versus ROA as a Measurement Goal
Financial institutions are continually trying to determine which analytical ratios are most suited to their business model. Two of the most preferred ratios are Return on Equity (ROE) and Return on Assets (ROA). Each ratio provides insight into a financial institution that allows management to make strategic decisions that can dramatically affect its structure and profitability. In the case of credit unions, ROA has been the predominant analytical tool to measure profitability; however, ROE is just as comprehensive and could be the better indicator.
Letís first take a look at how it is calculated. Return on assets equals Net Income divided by Total Assets. This tells us how efficient we are at earning returns per dollar of assets. Return on equity is calculated by dividing Net Income by average Equity. This tells us how efficiently we use our invested capital. We can make the case that both tell us the same thing, but that is not necessarily true as ROA tends to be the more volatile ratio. Letís look at an example to explain.
Total Assets of Credit Union A: $100M
Credit Union A has an ROA of one percent and an ROE of 10 percent. Now, suppose that Credit Union A borrows $10M and invests in car loans, and letís assume that net income remains the same at $1.0M. The capital-to-asset ratio is now 10/110 or 9.1 percent. As a result of this transaction ROA has decreased from one percent to 0.909 percent while ROE has remained at 10 percent. So while ROA had a 9 percent change, ROE experienced no change at all. Since ROA is dependent on the denominator (total assets in this case) the ratio can fluctuate dramatically with no real change in income. If we
modify our example to say that NI will increase by 20K, then the results differ slightly, but we come to the same conclusion. ROA will be $1.02M/$110M or 0.927 percent while ROE will increase to $1.02M/$10M or 10.2 percent. In percentage terms, ROA decreased by 7.3 percent while ROE increased by 2 percent. As long as the increase in total assets in percentage terms is greater than the increase in NI, ROA will decrease faster than ROE will rise.
While ROE may be more stable than ROA, presenting a more accurate income picture from period to period, it is not without flaws. The drawback to ROE is that it inherently does not take into consideration financial risk.
What is financial risk? Financial risk in a credit union is represented by the increased ratio of liabilities to assets, causing increased pressure on the credit union to maintain margins. As we saw in the earlier example, the credit union becomes more leveraged as it increases its borrowing position, putting more pressure on management to earn a positive spread to pay off the liability cost. Since ROE does not take into consideration this leverage position, it does not identify any risk from the increase in liabilities, while ROA, on the other hand, does.
What we find when analyzing these two ratios is that both have advantages in specific situations. ROA is more suitable when credit unions are building up a balance sheet through leveraging because it takes into consideration that added risk of the additional fixed costs. ROE is more suitable when a credit union has steady growth through member demand because it lacks the volatility associated with ROA, revealing true profitability.
Emily Hollis is a CFA and president of ALM First Financial Advisors, LLC in Dallas, Texas. Contact her at 800-752-4628 or firstname.lastname@example.org.
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