Return on investment comes in many different forms. In general, the return on investment is calculated by dividing the profit made from a particular investment by the cost of the investment. The higher the return on investment, the more profitable the stock is considered to be. Return on assets and return on equity operate in the same way.
Return on Assets
Return on assets is calculated by dividing company earnings by total assets. Company earnings are found on the income statement as net income, and total assets can be found on the balance sheet.
Return on Equity
Return on equity is similar to return on assets, but instead of dividing earnings by total assets, earnings are divided by total equity. Total equity is listed as stockholders' equity on the balance sheet.
Assets vs. Equity
To understand the difference between return on assets and return on equity, you should understand the balance sheet equation. By this equation, assets equal liabilities plus stockholders' equity. In other words, all assets are either paid for with debt or investment funds. It is preferable for a company to have more equity than debt.
Return on assets tells the investor how much the company is making for each dollar invested in assets. For instance, if a company has earnings of $1 million and total assets of $2 million, the return on assets is .5. This means that 50 cents are made on every dollar invested in company assets. The higher the return on assets, the more efficient management is at managing company assets. Likewise, if stockholders' equity is $1 million, then return on equity is calculated as $1 million divided by $1 million, or 1. This means that for every dollar invested in equity, a dollar is created in assets. It also means that the company has no liabilities.