Profit Margin for ROA

Question

Describe the difference between the profit margin for ROA and the profit margin for ROCE. Explain why
each profit margin is appropriate for measuring the rate of ROA and the rate of ROCE, respectively.

Sample Solution 

The profit margin for ROA excludes subtractions for the cost of debt and equity financing, whereas the profit
margin for ROCE makes subtractions for the cost of all financing senior to the common shareholders (that
is, debt and preferred stock financing).

The purpose of ROA is to provide a measure of how well a firm has used assets to generate earnings without considering how the firm financed those assets. Excluding the
cost of all financing in the numerator provides this measure of return.

The purpose of ROCE is to provide a measure of how well a firm has used the capital (contributed capital plus retained earnings) to generate
earnings for the common shareholders. Subtracting interest expense on borrowing and preferred dividends
provides this measure of return.