ROA > ROE Explanation
My First Question: Say ROA > ROE, is this explanation correct?
1) If ROA = Net Income / Total Assets and ROE = Net Income / Equity: ROA > ROE. because... (A) Net Income is increasing at a faster rate than Total Assets are increasing. This may occur if a company is raising equity to fund operations. As a result, the capital doesn't make it to the balance sheet because it's most likely going to spent. Therefore, Equity is increasing more than total assets are increasing.
2) If ROA = EBITDA / Total Assets and ROE = Net Income / Equity: ROA > ROE, because... (A) EBITDA excludes capital structure. Therefore, if a significant of debt capital is raised, EBITDA is not impacted by interest expense whereas Net Income is. Thus EBITDA > Net Income and Total Assets > Equity. (B) EBITDA is not impacted by Capex. Thus, if Capex spend is increasing, EBITDA > Net Income because Net Income will decrease as a result of depreciation expense. (C) EBITDA is not impacted by taxes. Thus, if DTAs are increasing or DTLs are decreasing, EBITDA > Net Income because Net Income will decrease as a result of paid taxes.
My Second Question: When would be prefer to use ROA = EBITDA / Total Assets over ROA = Net Income / Total Assets?
My Third Question: Is it best practice to use Avg. Assets instead of Total Assets due to the time period differences of the B/S and I/S?
This is what I think(although I could very well be wrong because I'm a noob and have only finished freshman year).
ROE= ROA * EM(equity multiplier)
EM= (Average total assets)/(Equity)
If ROE is less than ROA, the EM must be less than 1. The only way EM can be less than 1 is if equity is greater than average total assets. However, we know that Assets= Liabilities + Stockholders' Equity, so by default, equity can never be greater than average total assets. Therefore, I don't think it's possible for ROE to ever be greater than ROA. If the company had no liabilities, then assets would equal SE and ROA would equal ROE.
Also, my accounting class taught ROA as solely (net income/average total assets) and ROE as (net income/average common stockholders' equity). Are you even allowed to use EBITDA for those ratios? Is that a banking thing? As far as I was aware, you only use net income as the numerator for ROA and ROE. For your last question, I definitely would use average total assets because there will most likely be a difference between balances at the beginning and end of the fiscal year. Plus, the formula for ROA uses average total assets.
RE 1: Equity Assets if you have other laibilities on the balance sheet (debt, trade payables, etc) --> just math
RE 2: this does not always hold. A and B generally correct, C: T is tax expense, not cash out, DTL/DTA you will only seen on BS and CF statement.
Q2: When comparing companies with different capital structures. For instance hotel company that rents it's hotels vs one that owns them. Gives mores insight in operational perforamnce, rather than combination of operational performance and cap structure combined.
Q3: Yes. You could also take average equity.
Thank you. For (C), the tax expense still reduces net income whether it’s cash out or not. That being said, EBITDA > Net Income. Am I thinking about this wrong? I don’t quite understand your comment on (C)
That doesn't change the fact that it's mathematically impossible for ROA>ROE. At best, ROA can equal ROE.
EBITDA should be > net income, not smaller (unless there is a one off gain etc.)
EDIT: LOL dude, first change your answer and then throw MS.. for real?
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