How do ROA and ROE differ in relation to leverage?

• A. ROA measures asset efficiency; ROE measures profitability
• B. ROA = Net Income / Total Assets; ROE = Net Income / Equity; ROE cannot exceed ROA
• C. ROE can be higher due to financial leverage
• D. ROA uses liabilities in denominator

Answer: (C)

The key idea here is how debt financing changes what each return measures. Return on assets (ROA) looks at how much profit a company generates from all the assets it owns, while return on equity (ROE) looks at how much profit is earned for the shareholders’ investment.

ROA = Net Income / Total Assets, and ROE = Net Income / Equity. Since total assets equal equity plus liabilities, adding debt increases assets without increasing equity by the same amount. That means the denominator in ROA grows with assets, but ROE’s denominator (equity) grows more slowly or even shrinks if the company borrows, so ROE can end up larger than ROA. In fact, ROE ≈ ROA × (Total Assets / Equity), which is greater than ROA when there is debt financing.

For example, with a net income of 100, assets of 1000, and equity of 800, ROA is 10% while ROE is 12.5%. If the company takes on more debt without raising NI, ROE climbs further due to leverage.

So the correct idea is that ROE can be higher because financial leverage amplifies the equity return relative to the asset base.