I get a following example to illustrate what I mean.
For example, there are data of two companies A and B () as follows:
Company A Company B
Equity $ 50 millions $ 100 millions
Net profit after tax $ 10 millions $ 20 millions
Debt 0 $ $ 40 millions
Looking at above figures, we can see that two companies have similar ROE ratio, they achieved 20% together mean profitability of the business per 1 year of two companies are the same and over average.
However, it should be noted that company B only did it with a debt $ 40 millions equivalent debt/equity ratio is 40%, while company A no loan a dime.
This could mean?
In terms of absolute, net profit after tax of the company A is $ 10 millions less than the $ 20 millions of the company B, but relative proportions of the two companies are equal to 20%.
It shows that effectiveness of using capital of company A is better than company B. The most obvious evidence is assume for some reason the $ 40 million debt of B is ceased and B does not borrow more, then company B will not or hard to make ROE ratio like the first. Instead of, B will make a ratio of less value 20% corresponding the net profit after tax of less value $ 20 millions.
Therefore, there is another way to compare two companies in using of shareholder capital is to use both ROE and ROA simultaneously.
ROA = Net profit after tax / (Equity + Debt)
When ROE is the same, we will consider ROA. If ROA of which the company is larger mean that more effective using shareholder capital.
Returning to the example above, we see:
ROA (A) = 10 / (50 +0) = 20%
ROA (B) = 20 / (100 +40) = 14.44%
Thus, we see ROA (A)> ROA (B) demonstrate A more than B in using equity for while ROE is the same but A does not make the risk of capital because involved in debt.
One more thing else while looking for good companies, it should attention to companies with high ROE ratio and more, ROE and ROA have approximately the same as much as possible. Because it means the company is doing well without much debt and that is long-term.
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