Ratio analysis
Returns: ROA, ROE and ROIC
Profit relative to the capital that produced it — on average balances, with consistent numerators and denominators.
Learning objectives
- Calculate ROA and ROE on average balances
- Calculate NOPAT and ROIC on average invested capital
- Explain why ROE and ROIC differ and what leverage does to ROE
Margins say how much profit each riyal of sales produces. Returns say how much profit each riyal of capital produces — the question owners and lenders ultimately care about. A 20% margin on a business that needs enormous capital can be a worse investment than a 5% margin on one that needs very little.
The key discipline is matching numerator and denominator: a profit measure belongs with the capital that earns it.
- ROA relates net income to all assets.
- ROE relates net income (shareholders' profit, after interest) to shareholders' equity.
- ROIC relates operating profit after tax (NOPAT, before interest) to the capital provided by both lenders and shareholders.
ROA = NI ÷ avg TA ROE = NI ÷ avg Equity ROIC = NOPAT ÷ avg IC
- NI
- net income for the year
- avg
- (opening balance + closing balance) ÷ 2 — profit is earned over the year, so use the average capital employed
- NOPAT
- EBIT × (1 − effective tax rate); effective tax rate = tax expense ÷ profit before tax
- IC
- invested capital = debt + equity − cash
Included with a Formula Quest membership
The rest of this lesson is for members. Members get the full lesson, including its 3 graded exercises, and every other Finance Quest lesson.