Question

Company A has a return on assets of 4% and a return on equity of 15%, while company B has a return on assets of 4% and a return on equity of 10%. Is company A more likely to be a better investment for shareholders than company B? Under what circumstances would you prefer to be a shareholder of company A?

Answer 1

Return on Assets, ROA = Net Income/(Debt + Equity) = EBIT/Total Assets

It measures the return obtained on total assets of the company, i.e., money of debtholders as well as investors

Return on Equity, ROE = Net income/Equity = EBT/Total Equity

It measures the return obtained on investor's money.

Since both the companies have same ROA, both companies manage the total assets at same effectiveness, but investors get higher returns in company A (15%). Therefore, Company A is better investment for the shareholders than Company B.

Company A is a right investment as long as its ROA is higher than other companies, otherwise company with low ROA but higher ROE is just trying to give a false impression about the company's futures.