1. Computing ROE and ROA: Both ROA and ROE measure profitability. Which one is more useful for...
1. Computing ROE and ROA: Both ROA and ROE measure profitability. Which one is more useful for comparing two companies? Why?
2. (Graded) Ratio Analysis: Consider the ratio EBITD/Assets. What does this ratio tell us? Why might it be more useful than ROA in comparing two companies?
3. Return on Investment: A ratio that is becoming more widely used is return on investment. Return on investment is calculated as net income divided by long-term liabilities plus equity. What do you think return on investment in intended to measure? What is the relationship between return on investment and return on asset?
Homework Answers
1. Computing ROE and ROA: Both ROA and ROE measure profitability. Which one is more useful for comparing two companies? Why?
ROE is Net income/Average equity and ROA = EBIT*(1-t)/Average total assets.
While ROE measures return on shareholders' funds ROA measures return on total assets, which is equal to total funds supplied by creditors and shareholders.
ROA is more appropriate in comparing two companies.
The reason is that ROE is based on 'after tax income after providing for interest on debt' and on 'funds supplied excluding debt'.
As the quantum of interest, which in turn is based on each company's financing policy with respect to its capital structure, can differ widely between firms, ROE does not a reflect the relative operating efficiency of the firms.
In contrast, the ROA measures the efficiency of a firm in using its total resources (total assets) and is not affected by the extent of financial leverage. Hence, the ROA is more appropriate in comparing the profitability of firms.
2. (Graded) Ratio Analysis: Consider the ratio EBITD/Assets. What does this ratio tell us? Why might it be more useful than ROA in comparing two companies?
The ratio expresses the 'earnings before interest taxes and depreciation' as percentage of total assets.
The ratio is an improvement over the ROA, which uses NOPAT in the numerator.
EBITDA excludes taxes and depreciation also, in addition to excluding interest.
The exclusion of depreciation and taxes provides refinements to make the ratio more comparable between firms.
The first is that it converts the income on cash basis by excluding the non cash item of depreciation.
Secondly, difference in depreciation methods and the aging of the assets will affect the quantum of depreciation, and by removing depreciation expense, the profit parameter becomes more comparable.
Finally, tax effect could be different on different companies due to the tax structure, which is also eliminated.
Return on Investment: A ratio that is becoming more widely used is return on investment. Return on investment is calculated as net income divided by long-term liabilities plus equity. What do you think return on investment in intended to measure? What is the relationship between return on investment and return on asset?
Return on investment is intended to measure the return on capital employed or return on net operating assets. Current liabilities that do not bear interest, are deducted from total operating assets.
Hence, while return on assets reflects the return on total assets (total funds invested), return on investment reflects the return on net operating assets (funds for which there is a cost) only.
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