Two companies report the same 8% return on equity. One levered up to get there; one earned it on operations. Profitability ratios only tell you something once you decompose the inputs and watch the trend.
Return on assets (ROA) and return on equity (ROE) look standardized until you try to compute them on two firms. The numerator "return" can be net income, net income before extraordinary items, net income available to common, EBIT, EBIT(1 − t), or earnings before interest, taxes, depreciation, and amortization (EBITDA). The denominator "assets" can be ending, beginning, simple-average, or operating-only assets (excluding goodwill and idle assets). Equity can be total equity, common equity, or tangible common equity (after subtracting goodwill and intangibles).
KEY: Same firm, four legitimate ROEs depending on whether you use ending vs average equity and whether you strip preferred dividends from the numerator. State your convention before comparing.
The exam expects you to recognize:
- Average balance sheet values pair with flow numerator (NI is a flow over the year; assets are a stock).
- Net income available to common = NI − preferred dividends. Use it when ROE is "return on common equity."
Common mistakes
- Using ending equity in ROE when the period had a large issuance or buyback. Use average equity to pair the stock with the flow. Ending equity understates ROE after a buyback and overstates it after an issuance.
- Forgetting to subtract preferred dividends from the ROE numerator. Return on common equity uses NI minus preferred dividends. Skipping the subtraction inflates ROE.
- Treating a change in estimate as a restatement. Useful-life and bad-debt changes are prospective only; prior periods are not restated. Method changes (FIFO to weighted average) are retrospective.
Bottom line
- ROA = Net Income / Average Total Assets; ROE = Net Income to common / Average Common Equity. Numerator (NI, EBIT) and denominator (ending vs average) definitions vary, so always state which version you used.
- DuPont: ROA = Net Margin × Asset Turnover; ROE = ROA × Equity Multiplier. Decompose before diagnosing; rising leverage lifts the equity multiplier.
- Reported income is not one number: it reflects estimates, method choices, disclosure incentives, and user purpose, so creditor, equity, and tax income differ for the same firm.
- Three margins from one income statement: Gross = (Revenue − COGS)/Revenue; Operating = OI/Revenue; Net = NI/Revenue. They localize pressure to COGS, OpEx, or below-the-line.
Exam shortcut
When two firms report the same ROE, decompose with DuPont before judging. Equal ROE from net margin 15% and equity multiplier 1.5 is not equal to ROE from net margin 5% and equity multiplier 4.5. Leverage is doing the work in the second. When the question asks "which margin reveals the issue," walk down the income statement: GPM for cost of sales, OPM for operating overhead, NPM for interest/tax/non-operating.
The full lesson (about 2,148 words, 14 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2A3
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