What’s it: Operating ROA is a profitability ratio to measure how well a company is using its assets to generate profits from its core business. We calculate it by dividing operating profit by total assets.
Operating ROA provides insights similar to conventional ROA but isolates and focuses on a more specific aspect, namely core business. And a higher operating ROA is better, indicating the company generates high operating profit utilizing its assets.
Why use operating ROA?
Return on assets (ROA) and operating ROA tell us how successfully a company uses its assets to generate profits. Under ROA, we measure it by using net income as the numerator, which is influenced by operational or non-operational aspects. In contrast, operating ROA focuses on operational aspects by using operating profit in the calculation.
Analysts and investors use operating ROA to determine how well a company’s core business is performing by associating recorded operating profit with the resources used to generate it. They ignore non-operational aspects such as proceeds from asset sales, interest income, interest expense, taxes, and investment returns.
Including non-operational components can be misleading when evaluating how well the core business is profiting. For example, when we analyze how profitable a food business is, we focus on how many products are sold and what costs are involved. We then examine how much was sold, how much it cost to produce it, and how much it costs to operate the day-to-day business. And, when we include interest income and expense when examining the food company’s profits, it may sound odd because both are not part of the company’s core business.
In addition, non-operational items sometimes appear once with significant value. For example, the company recorded the sale of fixed assets this year. As a result, it increased net profit significantly this year. However, net income could drop dramatically in the next year because this item no longer appears on the income statement.
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As a result, including such items in the profit calculation will volatile the numbers we get. Therefore, we prefer to use operating income rather than net income.
Likewise taxes, it varies in different countries. For example, a company may focus on a low-tax country such as a developing country. Meanwhile, competitors may focus on high-tax countries with a high per capita income, such as developed countries. As a result, competitors will report a relatively higher tax burden than the company. Because net income and ROA account for the taxes, their performance is less comparable due to these tax variations.
How to calculate operating ROA?
Calculating ROA requires us to divide operating profit by total assets. We use operating profit as the numerator. It equals revenue minus the cost of goods sold (COGS) and operating expenses (selling, general, and administrative expenses). Companies usually present it as a separate account on the income statement.
Meanwhile, as the denominator, we use total assets. A common practice is to use the average total assets in the last two years, calculated by adding last year’s total assets to this year’s total assets and dividing the result by 2.
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- Operating ROA = Operating profit/Average total assets
- Operating profit = Revenue – COGS – Operating expenses
Remember, operating profit is not the same as the money the company makes from its core business. The calculation still includes non-cash items such as depreciation and amortization expenses.
How to interpret operating ROA?
As explained earlier, operating ROA is a metric to measure how profitable the company’s core business operations are, measured by what percentage of operating profit is generated from the assets used. A higher ratio is preferred because it shows the company successfully utilizes its resources to generate higher profits.
Conversely, a lower ratio is not preferred. It indicates problems in core business operations as existing resources generate less profit.
Comparing the ratio historically helps us know how effectively and efficiently a company generates profits using its assets. When it goes up, it indicates better performance.
For example, the company uses existing resources to generate more sales. As a result, asset turnover is higher, indicating the company can effectively leverage assets to earn more revenue.
At the same time, the company may also be efficient in utilizing assets to generate these revenues. Thus, the company bears low operating costs. In other words, the company generates revenue at a low cost.
In the end, high income and low expenses lead to higher profits and operating ROA.
Companies compete with each other in their core business. They also face the same opportunities and threats in the business environment, both competitive and macro environments.
How successfully they exploit opportunities and minimize those threats depends on their strategy. And operating ROA is one of the metrics to evaluate it by relating the profit recorded from the core business with the resources they have to compete and operate the business.
In some cases, a company may generate a higher operating ROA than the previous period. But, if we compare with competitors or industry averages, the percentage is lower than them. So, saying the company’s performance is good could be a premature conclusion. The company may improve its operating performance, but it is not enough to beat its competitors.
Therefore, we need to compare its operating ratio with its industry average to give a fairer judgment. If it’s higher, it’s better. Conversely, if it is lower, it is bad.
What to read next
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- Net Profit Margin: Formula, Calculation, Interpretation
- Return on Assets: Calculation and Interpretation
- Operating ROA: Formula, Calculation, and Interpretation
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- EBITDA Margin: Formula, Calculation, and Interpretation
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