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What’s it: Return on assets (ROA) is a profitability ratio to measure how well a company uses its assets to generate profits. This ratio tells us about the returns the company gets on its assets. We calculate it by dividing net profit by total assets, expressed as percentages.
A higher ratio is better, indicating the company is making better use of its assets and thus generating higher profits. A low ratio indicates the opposite.
Why is the return on assets important?
Companies invest in assets to make a profit. The higher the profit recorded from each asset used, the better. And, ROA shows us how high the profit is relative to the assets owned.
ROA gives us insight into a company’s efficiency in using its assets to generate profits. It is best used when comparing it to similar companies or previous performance. Thus, we know whether the company is more efficient and productive over time and better than its competitors in the industry. Then, translating it with other financial ratios helps us understand financial health.
How to calculate return on assets?
We calculate ROA by dividing net income by total assets. We find net income, or net profit, in the income statement. Meanwhile, total assets are on the balance sheet. Then, we can use the average total assets to avoid variations in asset values due to seasonal factors.
- ROA = Net profit/Average total assets
Adjusted ROA
Using net income as the numerator in calculating ROA has its drawbacks. First, it only reflects returns to shareholders, not to creditors.
In fact, companies finance their assets through two sources: equity and debt. Equity comes from shareholders. Meanwhile, debt can come from creditors, either loans or other sources such as bonds.
So, if we use net income, it only reflects the return to shareholders because we’ve subtracted interest expense to calculate it. In fact, interest expense represents a return to creditors.
Therefore, some analysts prefer to add interest expense back to net income. They then adjust the interest expense to taxes. Here is the formula:
- Adjusted ROA = [Net profit + Interest expense (1 – Tax rate)] / Average total assets
Return on assets vs. asset turnover
ROA and asset turnover ratio may sound similar. However, the two are different. We calculate the asset turnover ratio by dividing revenue by total assets. In other words, we use revenue as the numerator in the calculation. Meanwhile, ROA uses net income as the numerator.
Then, the asset turnover ratio measures how effectively the company utilizes its assets. However, this ratio does not consider the costs involved – look at the calculations, we only use revenue. In other words, it doesn’t take efficiency into account.
Take a simple case. A company reports high asset turnover and generates more revenue. But, it may be a poor profit because the company incurs many expenses to generate revenue. As a result, the company’s ROA is low.
In other cases, the company posted moderate asset turnover – still within the industry average. But, to produce it, the company is far more efficient than the industry average. As a result, it posts a higher ROA.
And, since the company’s motive is profit maximization, not revenue, the second case is preferable. To make more money, a company must not only sell more goods (high revenue) but must also spend less money doing so (low cost).
Let’s take a simple example. The two companies are assumed to have exactly the same total assets of $4 million. Company ABC generated revenues of $2 million while Company XYZ generated $1.8 million. However, to generate this revenue, Company ABC incurred a total expense of $1.52 million, more than Company XYZ ($1.2 million).
In the above case, Company ABC has a higher asset turnover than Company XYZ. Here’s the calculation:
- Company ABC = $2 million / $4 million = 0.5
- Company XYZ = $1.8 million / $4 million = 0.45
However, because it is more efficient in generating revenue, Company ABC has better profitability than Company XYZ, as well as its ROA.
- Company ABC’s ROA = ($2 million – $1.52 million) / $4 million = 480,000 / $4 million
- Company XYZ’s ROA = ($1.8 million – $1.2 million) / $4 million = 600,000 / $4 million
How to interpret the return on assets?
ROA shows how well the company is getting a return on the money invested in assets. The higher the ROA, the better because the company generates higher returns.
As this ratio increases over time, the company increases its revenue more efficiently. Thus, the investments spent on assets yield more profits than ever before.
In contrast, a decrease in the ratio indicates an unfavorable condition. The company may over-invest in assets but not generate commensurate revenue – thus, low asset turnover. And at the same time, the company is not utilizing its assets in a more cost-efficient manner. Thus, the high costs further burden the lower revenue.
Comparing it to the industry average
ROA can vary between companies, depending on the industry in which they operate. For example, technology companies will generate a different average ROA than those operating in the food industry.
In addition, companies in different industries face different business environments with varying opportunities and threats. For example, food companies tend to have more competitors than aircraft companies. Higher competitive pressures put pressure on profit margins and, ultimately, net profit.
For such reasons, we need to compare ROA with companies in the same industry. Thus, we know how efficiently a company utilizes its assets compared to competitors when facing the same business environment. And a higher ratio is preferred as it indicates better performance.
