Profitability ratios: margins, ROA and ROE
Compare two real rivals' margins and returns, and find out when a return on equity stops meaning anything: Home Depot and Lowe's.
FinanceReading the accounts like an analystAbout 9 min: 9 readingUpdated
General education, not financial advice.
- Calculate gross, operating and net margins
- Calculate return on assets and return on equity on average balances
- Recognise when equity is too small or negative for ROE to mean anything, and use a better measure
Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.
Reading the accounts like an analyst: lesson 3 of 5
- Reading the accounts like an analyst
- The three statements and how they link 10 min
- Common-size statements and trends 9 min
- Profitability ratios: margins, ROA and ROE 9 min
- Efficiency ratios and the cash conversion cycle 9 min
- DuPont analysis: where ROE comes from 10 min
Pairs with any financial statement analysis text (the chapters on profitability and return on invested capital)
Mission
From: a portfolio manager Due: end of the week
A data screen says Home Depot earns a 145% return on equity and Lowe's a negative one. That can't be right about the businesses. Using their latest 10-Ks, give me a short table and a paragraph: how profitable is each one really, and which measure should we use to compare them?
The documents (millions of dollars; Home Depot's year to 1 February 2026, 10-K filed 18 March 2026; Lowe's year to 30 January 2026, 10-K filed 23 March 2026):
| Home Depot | Lowe's | |
|---|---|---|
| Net sales | 164,683 | 86,286 |
| Gross profit | 54,865 | 28,885 |
| Operating income | 20,890 | 10,153 |
| Interest expense (Lowe's: net) | 2,412 | 1,406 |
| Earnings before tax | 18,602 | 8,747 |
| Income tax | 4,446 | 2,093 |
| Net earnings | 14,156 | 6,654 |
| Total assets: start → end | 96,119 → 105,095 | 43,102 → 54,144 |
| Shareholders' equity: start → end | 6,640 → 12,813 | −14,231 → −9,917 |
From the reports: Lowe's calls its equity a "shareholders' deficit". During the year Home Depot's SRS subsidiary bought GMS, and Lowe's bought Foundation Building Materials, a building-supply distributor, and Artisan Design Group, which designs and installs interiors for home builders.
What it is
The toolkit for this job.
How much of each sale is kept (all divided by revenue):
- Gross margin = gross profit ÷ revenue.
- Operating margin = operating profit ÷ revenue (before interest and tax).
- Net margin = net income ÷ revenue (after everything).
How much is earned on what's invested (on average balances, (start + end) ÷ 2, because profit is earned over the whole year):
- Return on assets (ROA) = net income ÷ average total assets.
- Return on equity (ROE) = net income ÷ average shareholders' equity.
- ROA before financing = (net income + interest × (1 − tax rate)) ÷ average total assets. Net income is after interest paid to lenders, while assets are funded by lenders and owners alike; adding back after-tax interest puts companies with different debt on the same footing.
Check the base. ROE divides by equity, which is what's left after liabilities. Companies that buy back a lot of shares can shrink equity to almost nothing, or below zero, without the business changing. Then ROE is huge, negative or meaningless. Use a return on assets or on invested capital (debt plus equity, less spare cash) instead, and say which.
Questions an analyst asks
- Does this ratio describe the business, or its financing?
- What is the bottom of the ratio, and what happened to it this year?
- Is profit for the same owners as the capital it's divided by?
- Did anything change the asset base during the year?
Why it matters
A high margin and a high return are different things, and a high ROE can be produced by financing rather than by the business. Investors care about the return on the money tied up in a company; margins explain where it comes from. Choosing the wrong measure can make a weaker business look stronger.
Worked example
Harbour Tools, an imaginary wholesaler (thousands): revenue 2,000; gross profit 700; operating profit 240; interest 40; tax 50 (25% of 200); net income 150; total assets 1,400 → 1,600; equity 580 → 620.
- Gross margin 700 ÷ 2,000 = 35%; operating margin 240 ÷ 2,000 = 12%; net margin 150 ÷ 2,000 = 7.5%.
- ROA = 150 ÷ 1,500 = 10%. ROE = 150 ÷ 600 = 25%.
- ROA before financing = (150 + 40 × 0.75) ÷ 1,500 = 180 ÷ 1,500 = 12%.
ROE is far above ROA because equity is only 600 of the 1,500 of average assets; the rest is funded by liabilities.
Common mistake
Mixing a top and a bottom that don't belong together: group profit over the parent's equity when there are minority owners; net income (after interest) compared across companies with very different debt; or any ratio on an equity figure that is tiny or negative. Each ratio should compare a profit with the capital that earned it.
More detail: return on invested capital
Return on invested capital (ROIC) compares operating profit after tax with the money invested by lenders and owners: debt plus equity, less spare cash. It isn't distorted by buybacks, because buying back shares with borrowed money swaps one kind of capital for another. Firms define it differently (with or without leases, goodwill, cash), so always write down your formula. Both Home Depot and Lowe's publish their own ROIC figures in their 10-Ks, with their definitions.
Key terms
- gross margin
- gross profit ÷ revenue
- operating margin
- operating profit ÷ revenue
- net margin
- net income ÷ revenue
- return on assets (ROA)
- net income ÷ average total assets
- return on equity (ROE)
- net income ÷ average shareholders' equity
- shareholders' deficit
- negative equity: liabilities exceed assets on the balance sheet, often after large buybacks
Practise the key terms
Tap a card to turn it over. 6 cards.
| Front | Back |
|---|---|
| gross margin | gross profit ÷ revenue |
| operating margin | operating profit ÷ revenue |
| net margin | net income ÷ revenue |
| return on assets (ROA) | net income ÷ average total assets |
| return on equity (ROE) | net income ÷ average shareholders' equity |
| shareholders' deficit | negative equity: liabilities exceed assets on the balance sheet, often after large buybacks |
Task
Send the portfolio manager:
- a table of each company's gross, operating and net margins, ROA, ROE and ROA before financing;
- one paragraph: how profitable is each, really, and which measure to use;
- one sentence on what the ratios can't yet tell you this year.
Model answer
Show the model answer
| Home Depot | Lowe's | |
|---|---|---|
| Gross margin | 33.3% | 33.5% |
| Operating margin | 12.7% | 11.8% |
| Net margin | 8.6% | 7.7% |
| ROA | 14.1% | 13.7% |
| ROE | 145% | not meaningful |
| ROA before financing | 15.9% | 15.9% |
Workings: average assets 100,607 and 48,623; average equity 9,726.5 and −12,074; tax rates 4,446 ÷ 18,602 = 23.9% and 2,093 ÷ 8,747 = 23.9%. ROA before financing: (14,156 + 2,412 × 0.761) ÷ 100,607 and (6,654 + 1,406 × 0.761) ÷ 48,623. Lowe's interest is net of interest income; on the same basis Home Depot's would be 2,288 (after 124 of interest income and other), giving 15.8%: no change to the conclusion.
Home Depot and Lowe's are almost equally profitable businesses; the ROE figures measure their buybacks, not their operations. Both keep about a third of each sale as gross profit, and Home Depot's operating margin is about a point higher (12.7% against 11.8%). On the assets they use, both earn about 16% before financing costs. Home Depot's 145% ROE comes from a very small equity base (under 10 billion on average against 100 billion of assets), and Lowe's equity is negative after years of buying back more shares than its retained profits: neither ROE describes the business. Use return on assets before financing, or a stated return on invested capital, to compare them.
What the ratios can't yet tell us: both made large acquisitions serving building-trade customers during the year, so year-end assets include businesses that contributed only part of a year's profit. Next year's returns will show what those deals earn.
How the expert gets there. They see the impossible ROE and go straight to the equity line. They pick a measure that doesn't depend on equity, and make it fair by adding back interest at each company's own tax rate. They check what changed in the asset base (the acquisitions) before reading too much into the return.
What a reviewer would flag:
- Quoting a negative ROE as if Lowe's were losing money: its net income was 6.7 billion.
- Calling Home Depot "ten times more profitable" from ROE.
- Using year-end instead of average assets in a year of big acquisitions, which understates returns.
- Not stating the formula for the measure recommended.
Practice
Transfer: a steady return? A screen shows Nike's return on equity at about 23% in the year to 31 May 2025 and 22% in the year to 31 May 2026, "remarkably steady". From Nike's Form 10-K for 2026 (millions): revenues 46,309 and 46,398; net income 3,219 and 3,108; shareholders' equity 14,430 (May 2024), 13,213 (May 2025) and 14,865 (May 2026). Open the 10-K's MD&A before you agree. In three sentences: is profitability as steady as the screen says, and what would change your mind?
A model answer
The ratio is steady; what's inside it isn't. ROE on average equity was 3,219 ÷ 13,821.5 = 23.3% and 3,108 ÷ 14,039 = 22.1%, but 2026 cost of sales includes a 986 million benefit for IEEPA tariffs Nike has since recovered after the Supreme Court's February 2026 ruling: the 10-K says it largely offsets the tariff costs charged during the year. So 2026's profit is roughly what it would have been without those tariffs, and the ratio looks steady partly because a cost was refunded, which won't happen every year. Gross margin was 42.9% reported, and about 40.8% without the benefit. What would change my mind: margins holding in a year with no tariff refunds, or the refunds not being collected.
How the expert gets there: a steady ratio is checked as carefully as a moving one; they read the MD&A for anything large inside cost of sales before calling it stable.
What a reviewer would flag: "steady" without reading the MD&A; treating the benefit as pure profit when it offsets the year's tariff costs; ignoring that it won't recur.
In short
- Margins (gross, operating, net) measure what is kept from each sale.
- ROA and ROE measure what is earned on assets and on the owners' money, on average balances.
- Small or negative equity makes ROE huge, negative or meaningless.
- Add back after-tax interest to compare companies with different debt.
- When a ratio looks impossible, check its base.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
Revenue 800, operating profit 96. What is the operating margin?
Show answer
12%.
A company's ROE rose from 30% to 60% in a year when its profit was flat. What is the likely cause?
Show answer
Its average equity halved, for example through large buybacks; the business didn't improve.
Why add back after-tax interest when comparing returns on assets?
Show answer
Because interest is paid to lenders who also fund the assets; adding it back compares the businesses before the effect of how they are financed.
Further reading
- The Home Depot, Inc., Form 10-K for the year ended 1 February 2026; Lowe's Companies, Inc., Form 10-K for the year ended 30 January 2026 (SEC EDGAR).
- Corporate Finance Institute, Financial Analysis Glossary (margins, ROA and ROE).
- On this site: Common-size statements and trends; Comparing four companies.
Finished? Mark it done to fill in your leaf on the Finance map.