In this episode David and Eric return to unpacking the importance of Financial Analysis for a business. Today’s discussion will revolves around Return on Assets and Return on Equity – which involve numbers from both the Income statement and balance sheet. These two together are used in a powerful way to analyze business performance.

Linking back to a previous episode on valuation: If Company A has a higher ROA, then it will likely sell for more than an otherwise identical Company B, even if they both have the same EBITDA.

While you don’t need to understand ROA and ROE as well as maybe a financial analyst working in your company, you do need to know what these concepts are and understand that the more efficient you are with your assets the better everything is within your company.

While margin is important, don’t chase margin at the expense of the ROA. So many business owners do this to their detriment.

ROA is a good metric for evaluating the performance of management as management is tasked with putting the assets to work that they are stewards of.

ROE is a better metric for evaluating returns to the equity holders. One of the primary reasons that ROA and ROE differ is debt. When properly measured ROE can also be used as a measuring stick for comparing investments in your company with external investment options.

Don’t go through your whole career blind – thinking you’re creating amazing wealth when you aren’t. You don’t go through your whole career making 5% when you could have been making 10% for 20 years somewhere else. The main message for the audience is that these calculations exist. They provide additional insights into the efficiency and the level of profitability of the business, and it helps you make better decisions with things like: How efficient are we being? How can we be more efficient with our or utilization of assets? If you want to reinvest in the business – do you put more into this business or less into this business?

But be careful, ROA and, to a greater extent, ROE can be very distorted when taken directly from the financials statements of most private companies. We also discuss why and what to do about.

Additional resources on why profit isn’t everything and why you should pay attention to these metrics: https://www.emergedynamics.com/post/its-all-about-profit

And here is the math example we reference: https://www.emergedynamics.com/margin-vs-roa