How to analyze return on assets

The return on assets ratio, often called the return on total assets, is a profitability ratio that measures the net income produced by total assets during a period by comparing net income to the average total assets. In other words, the return on assets ratio or ROA measures how efficiently a company can manage its assets to produce profits during a period.

Since company assets’ sole purpose is to generate revenues and produce profits, this ratio helps both management and investors see how well the company can convert its investments in assets into profits. You can look at ROA as a return on investment for the company since capital assets are often the biggest investment for most companies. In this case, the company invests money into capital assets and the return is measured in profits.

In short, this ratio measures how profitable a company’s assets are.

Formula

The return on assets ratio formula is calculated by dividing net income by average total assets.

This ratio can also be represented as a product of the profit margin and the total asset turnover.

Either formula can be used to calculate the return on total assets. When using the first formula, average total assets are usually used because asset totals can vary throughout the year. Simply add the beginning and ending assets together on the balance sheet and divide by two to calculate the average assets for the year. It might be obvious, but it is important to mention that average total assets is the historical cost of the assets on the balance sheet without taking into consideration the accumulated depreciation.

The net income can be found on the income statement.

Analysis

The return on assets ratio measures how effectively a company can earn a return on its investment in assets. In other words, ROA shows how efficiently a company can convert the money used to purchase assets into net income or profits.

Since all assets are either funded by equity or debt, some investors try to disregard the costs of acquiring the assets in the return calculation by adding back interest expense in the formula.

It only makes sense that a higher ratio is more favorable to investors because it shows that the company is more effectively managing its assets to produce greater amounts of net income. A positive ROA ratio usually indicates an upward profit trend as well. ROA is most useful for comparing companies in the same industry as different industries use assets differently. For instance, construction companies use large, expensive equipment while software companies use computers and servers.

Example

Charlie’s Construction Company is a growing construction business that has a few contracts to build storefronts in downtown Chicago. Charlie’s balance sheet shows beginning assets of $1,000,000 and an ending balance of $2,000,000 of assets. During the current year, Charlie’s company had net income of $20,000,000. Charlie’s return on assets ratio looks like this.

As you can see, Charlie’s ratio is 1,333.3 percent. In other words, every dollar that Charlie invested in assets during the year produced $13.3 of net income. Depending on the economy, this can be a healthy return rate no matter what the investment is.

Investors would have to compare Charlie’s return with other construction companies in his industry to get a true understanding of how well Charlie is managing his assets.

The return on assets ratio, often called the return on total assets, is a profitability ratio that measures the net income produced by total assets during a period by comparing net income to the average total assets. In other words, the return on assets ratio or ROA measures how efficiently a company can manage its assets to produce profits during a period.

Since company assets’ sole purpose is to generate revenues and produce profits, this ratio helps both management and investors see how well the company can convert its investments in assets into profits. You can look at ROA as a return on investment for the company since capital assets are often the biggest investment for most companies. In this case, the company invests money into capital assets and the return is measured in profits.

In short, this ratio measures how profitable a company’s assets are.

Formula

The return on assets ratio formula is calculated by dividing net income by average total assets.

This ratio can also be represented as a product of the profit margin and the total asset turnover.

Either formula can be used to calculate the return on total assets. When using the first formula, average total assets are usually used because asset totals can vary throughout the year. Simply add the beginning and ending assets together on the balance sheet and divide by two to calculate the average assets for the year. It might be obvious, but it is important to mention that average total assets is the historical cost of the assets on the balance sheet without taking into consideration the accumulated depreciation.

The net income can be found on the income statement.

Analysis

The return on assets ratio measures how effectively a company can earn a return on its investment in assets. In other words, ROA shows how efficiently a company can convert the money used to purchase assets into net income or profits.

Since all assets are either funded by equity or debt, some investors try to disregard the costs of acquiring the assets in the return calculation by adding back interest expense in the formula.

It only makes sense that a higher ratio is more favorable to investors because it shows that the company is more effectively managing its assets to produce greater amounts of net income. A positive ROA ratio usually indicates an upward profit trend as well. ROA is most useful for comparing companies in the same industry as different industries use assets differently. For instance, construction companies use large, expensive equipment while software companies use computers and servers.

Example

Charlie’s Construction Company is a growing construction business that has a few contracts to build storefronts in downtown Chicago. Charlie’s balance sheet shows beginning assets of $1,000,000 and an ending balance of $2,000,000 of assets. During the current year, Charlie’s company had net income of $20,000,000. Charlie’s return on assets ratio looks like this.

As you can see, Charlie’s ratio is 1,333.3 percent. In other words, every dollar that Charlie invested in assets during the year produced $13.3 of net income. Depending on the economy, this can be a healthy return rate no matter what the investment is.

Investors would have to compare Charlie’s return with other construction companies in his industry to get a true understanding of how well Charlie is managing his assets.

Last updated on February 14, 2019

The return on assets formula calculates the net earnings generated by total assets during a period of time. Also known as ROA, this financial ratio shows how effectively a company uses its assets to generate money.

It tells an investor or a manager how much after-tax profit each dollar of assets generates. For example, ROA of 10% means that a company makes $0.10 of net income for every $1 of assets.

How to calculate return on assets?

Return on assets is calculated by dividing net income by average total assets. Return on assets is presented as a percentage, so this number should be multiplied by 100.

Alternative calculation

Another method of calculation of return on assets is to multiply net profit margin by assets turnover. This method is a bit more complicated than the first one because it needs more calculations. But if you analyse a company, you will have already known net profit margin and assets turnover ratio by the time you get to calculate ROA.

Return\;on\;assets = Net\;profit\;margin \times Assets\;turnover

Net profit margin is a relation between revenue (all the money received by a company during a period of time) and net income (revenue – cost of sold goods – operating expenses – interest – taxes – other expenses, i.e. the money a company actually earned). It’s tells us how much income is generated from the revenue.

Assets turnover informs us about a company’s ability to generate sales from its assets. It’s a ratio that measures a company’s total sales in relation to the average value of its assets.

Return on assets ratio explained

Since the main purpose of assets is to create income, ROA ratio helps investors and management to understand how well a company uses its property to create money. For example, ROA of 5% means that every dollar of invested capital generates 5 cents of net income.

As well as a lot of financial ratios, return on assets should be compared:

  • In time for the same company. By comparing ROA in time, we can create a trend and look for positive or negative changes.
  • With other companies in the same industry. It allows us to compare a given company with its competitors.

Return on investment tells how many assets a company should have in order to get a certain amount of profit. In other words, it tells us about how asset-intensive or asset-light a company is. Although, this number is different for every industry, as a reference point ROA 20% as assets-light.

For example, manufactories or transport companies are very asset-intensive because they need a lot of expensive equipment to operate. Software companies or law firms are very asset-light because software, computer programs and people create profit it such companies.

Examples of return on assets calculation

  • A company’s annual net income for the past fiscal year was $400,000
  • Total assets were $ 9,000,000 in the beginning of the year and $11,000,000 at the end of the year, which means average total assets were $10,000,000.

Return on assets for this company is calculated as:

This means that this company generated $0.04 of net profit for every $1 of assets, giving the ROA of 4%.

  • A company’s annual sales (revenue) for the past fiscal year were $600,000.
  • A sum of cost of sold goods, operating expenses, interest, taxes and other expenses was $200,000.
  • Total assets were $ 2,000,000 in the beginning of the year and $3,000,000 at the end of the year, which means average total assets were $2,500,000.
  • Net income was $400,000 (revenue – costs).

Step 1. Net profit margin

Step 2. Assets turnover

Step 3. Return on assets

Return\;on\;assets = 0.667 \times 0.24 = 0.16 = 15\%

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How to analyze return on assets

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“It’s clearly a budget. It’s got a lot of numbers in it.” –George W. Bush

What is Return on Assets?

Return on assets (ROA) is a profitability ratio that measures the rate of return on resources owned by a business. It is one of the different variations of return on investment (ROI). It measures the level of net income generated by a company’s assets.

Return on assets (ROA)

    a measure of a company’s ability to generate profit, computed as: net income divided by average total assets

Return on Assets Formula and Explanation

The return on assets is a cross-financial statement ratio. It makes use of “net income” derived from the income statement and “total assets” obtained from the balance sheet.

The formula for return on assets is:

Net Income ÷ Average total assets

Take note that it is better to use average total assets instead of simply total assets. This is because the net income represents activity for a period of time; however, total assets is measured as of a certain date. To somehow fix this mismatch, the average of the beginning and ending balance of total assets is used.

Example

Company A
2020 2019
Net income (from income statement) 8.3 million 5.6 million
Total assets (from balance sheet) 90 million 80 million
Company B
2020 2019
Net income (from income statement) 5.7 million 3.6 million
Total assets (from balance sheet) 45 million 30 million
Return on assets = Net income
Average total assets
Company A = 8.3
(90 + 80) ÷ 2
= 9.8%
Company B = 5.7
(45 + 30) ÷ 2
= 15.2%

Interpreting the Return on Assets

Assuming that the companies operate in the same industry and economic environment, it can be concluded that Company B did better in managing its resources to generate profits.

Just like other variations of rate of return, the higher the return on assets the better. A high return on assets means than the business was able to utilize its resources well in generating income. It is also noteworthy to mention that this ratio removes the effect of company size. As illustrated in the example above, even if Company A generated 8.3 million and Company B generated 5.7 million only, Company B was more efficient since it made more income for each dollar of its assets. Also, the return on assets becomes more useful when it is compared to the industry average or other benchmarks such as historical performance or a target return.

What Is Return on Assets (ROA)?

Return on assets is a profitability ratio that provides how much profit a company is able to generate from its assets. In other words, return on assets (ROA) measures how efficient a company’s management is in generating earnings from their economic resources or assets on their balance sheet.

ROA is shown as a percentage, and the higher the number, the more efficient a company’s management is at managing its balance sheet to generate profits.

Calculating Return on Assets (ROA)

Average total assets are used in calculating ROA because a company’s asset total can vary over time due to the purchase or sale of vehicles, land or equipment, inventory changes, or seasonal sales fluctuations. As a result, calculating the average total assets for the period in question is more accurate than the total assets for one period. A company’s total assets can easily be found on the balance sheet.

The formula for ROA is:

Net profit or net income which is found at the bottom of the income statement is used as the numerator. Net income is the amount of total revenue that remains after accounting for all expenses for production, overhead, operations, administrations, debt service, taxes, amortization, and depreciation, as well as for one-time expenses for unusual events such as lawsuits or large purchases.

Net profit also accounts for any additional income not directly related to primary operations, such as investment income or one-time payments for the sale of equipment or other assets.

ROA and ROE Give Clear Picture Of Corporate Health

Example of Return on Assets (ROA)

Exxon Mobil Corporation (XOM)

Below is the balance sheet from Exxon’s 10K statement showing the 2017 and 2016 total assets (highlighted in blue).   Note the differences between the two, and how this will affect the ROA.

How to analyze return on assets

Below is the income statement for 2017 for Exxon according to their 10K statement:  

How to analyze return on assets

Exxon’s ROA is more meaningful when compared to other companies within the same industry.

Here are the 2017 ROAs for comparable companies:

By comparing Exxon’s ROA to industry peers, we see that Exxon generated more profits per dollar of assets than Chevron or BP in 2017.

What Return on Assets (ROA) Means to Investors

Calculating the ROA of a company can be helpful in comparing a company’s profitability over multiple quarters and years as well as comparing to similar companies. However, it’s important to compare companies of similar size and industry.

For example, banks tend to have a large number of total assets on their books in the form of loans, cash, and investments. A large bank could easily have over $2 trillion in assets while putting up a net income that’s similar to companies in other industries. Although the bank’s net income or profit might be similar to an unrelated company and the bank might have high-quality assets, the bank’s ROA will be lower. The larger number of total assets must be divided into the net income, creating a lower ROA for the bank.

Similarly, auto manufacturing requires huge facilities and specialized equipment. A lucrative software company that sells downloadable programs online may generate the same net profits, but it could have a significantly higher ROA than its more asset-heavy counterparts. When utilizing this metric to compare productivity across businesses, it’s important to take into account what types of assets are required to function in a given industry, rather than simply comparing the figures.

What is Return on Assets?

Return on Assets is one of the efficiency ratios that use to measure and assess how efficiently the company’s assets are being used. The main indicators to measure the efficiency of assets in this ratio are Net Income and Total Assets.

Return on assets is calculated by using net income over the total assets that the entity uses to generate that Income.

This ratio could be used in the company where assets are the main resources that use to generate revenue. For example, a manufacturing company or hotel.

However, this ratio is not suitable to use to assess the company where assets are not the main revenue generator. For example, consultant or services companies.

Formula:

The formula of Return On Assets : Net Income / ( Total Assets)

  • Finding the Net Income is not as hard as it is normally provided in the income statement. Net Income is normally at a specific period of time. If you do a benchmark by comparing the ROA of one profit centre, investment centre or company. It is a good idea to select the Net Income in the same period of time. Otherwise, your analysis is non-sense.
  • For Total Assets, sometimes they use Average Total Assets. The most recommended is when the Average Total Assets are available, then it is recommended to select, but if it doesn’t, let use Total Assets. Whatever you use, there must be consistency.

What do I mean by that?

Well, let say you are comparing two investment centre of their Return on Assets. Then you should select the net income from the same period of time and the same nature of assets, say Total Assets.

Okay, now you have learned about the formula and explanation of Return on Assets. Let move to the example together,

Example and Calculation:

The following is the example of Return on Assets and to calculate it.

Example:

ABC Company has Not Income: USD 50,000,000 for the period 1 January to 31 December 2016 and the Total Assets at the end of 31 December 2016 was USD100,000,000. The total Assets at the beginning of the years was USD 90,000,000.

ABC Company is operating in the manufacturing industry and the Industry Average of ROA is: 1 Previous year, ROA of ABC Company was: 1.05.

Discuss ROA of ABC Company.

Answer:

Based on the formula about, the ROA is Net Income / ( Total Assets). As per the scenario, the Total Net Income for the year is USD 50,000,000. For Total Assets, in this case, we use Average Total Assets because the previous year Total Assets is available.

Average Total Assets is (USD 100,000,000/ USD 90,000,000)/2 = USD 95,000,000

Therefore, ROA = USD 50,000,000/ USD 95,000,000 = 0.52 or 52%

Return On Assets as Performance Measurement

In this part, we will discuss on the using of Return on Assets of Performance Management. This also include the advantages and disadvantages of using ROA.

As mention above, Return On Assets is used to measure the efficiency of assets using to generate the Net Income, and this is the Financial Indicators which normally use in the manufacturing industry.

This Return on Assets is normally benchmark with the industry average, competitor, and previous year. For better analysis, the trend of this ratio for at least three years would be more beneficial.

There are advantages and disadvantages of using ROA as a performance indicator in order to assess the company’s performance as well as to reward management.

For the advantages, the ROA uses the percentage, therefore, we could compare it to the other companies that have different size of assets. ROA also very to understand by non-accounting managers and also it is very easy to calculate.

Besides advantages, there are also many disadvantages to using ROA as performance indicators. ROA using accounting information for calculation and it is commonly affected by management judgment.

Accounting policies is one among those factors. ROA uses percentage but it does not show the real value added to the shareholders or the company.

The serious disadvantages of ROA are it motivate management to use the old assets and discourage them not to invest in the new assets.

Interpretation and Deep Analysis:

Now, let see how is this ROA mean to ABC Company.

Based on the calculation about, current ROA is only 0.52 while the previous year ROA was 1.05. Based on this ratio, we can say that the current performance is poor than the previous year in term of efficiency ( using assets to generate revenue).

This might be because of low productivity, decreasing demand or highly competitive in the market. However, compared to the industry average, ROA is 1, ABC Company still not performing well enough.

There are many reasons why ROA of ABC Company is decreasing. First, probably not all of the company assets are using.

Let say, their many machines are idle assets as the result of the low purchase order or no technical personnel stand by to control those machines. These could cause the company to generate less profit than the previous year and the industry average.

Another reason is the accounting technique used by the management of the company. ROA is significantly affected by accounting policy or it can simply mean management could trick on accounting policies to get the accounting result as they want.

For example, Not Income is affected by accounting depreciation which is mainly based on judgment.

An additional reason why the ROA of the company is decreasing probably because of this year managements have disposed many of the old assets and replace them the new one.

This movement of assets could cause a large amount of depreciation being a charge to these years and result from decrease Net Income.

Conclusion:

For better analysis and interpretation, all of the factors internal and external effect on the ROA should be included and taking into account like demand in the market or ROA of industry average as well as competitors.

Some internal factors like using old assets, replacement and changing the accounting policies also significantly affect ROA.

The return on assets ratio (ROA) for any individual company shows how effectively it has turned its investments into profits. The model uses the simple formula of net income divided by total assets. A company that has a higher ROA has made comparably more profit for the investment either the owners or individual investors have made. However, the formula must be interpreted knowledgeably in order for one to truly understand the success of the company’s management at turning a profit.

To understand ROA, use this example. Sam’s Internet company earns $1,000 a year. Sarah’s magazine earns $10,000 a year. To most people, investing in Sarah’s company would seem like a much better option at first glance. However, a knowledgeable investor asks Sam the total value of his assets, i.e., how much he paid to start his company’s operations. Sam’s assets total $100; this is the cost he incurred to set up his website. His ROA, then, is 100 percent, which is extremely high. The same investor asks Sarah the total value of her assets. She explains she required $20,000 from investors in order to obtain the equipment to print her magazine. Her ROA is only 50 percent. Therefore, an investor who places $100 in Sam’s company will make more in return on that $100 in a single year than an investor who places the $100 in Sarah’s company.

Debt to Equity Consideration

One important factor to understand when analyzing ROA is the fact that both equity and debt count as assets in the calculation. In the above example, if Sarah invested $10,000 of her own money and took $10,000 in loans, all $20,000 would count as her assets. However, it is clear to see that she is operating at a very high debt ratio. This could expose her to bankruptcy if a slow sales cycle were to occur. Always consider how much of a company’s assets are in debt when looking at this ROA ratio. A company with a slightly lower ROA but far less debt than another company may be a more advantageous and safer investment.

Industry Consideration

Some industries continue to operate with very low ROAs. For example, the automobile industry has an extremely high cost of entry. To begin making cars, a company must invest millions of dollars in equipment and factories, raising its total assets. However, the Internet sales industry is on the exact opposite end of the spectrum. A company like Google or eBay can start up with very little capital investment. Therefore, some industries will permanently operate at higher ROAs than others. This does not mean you should not invest in automobile manufacturers. It does mean, though, that you should compare one manufacturer to another in its own industry if you are considering ROA as a factor in your investment. Within an industry, a company with a higher ROA will be, for the most part, a more profitable company. Using this figure in addition to factoring in debt to equity ratios can give you a clear picture of how well an individual business manages its assets and puts them to work.

Sure, it’s interesting to know the size of a company, but ranking companies by the size of their assets is rather meaningless unless one knows how well those assets are put to work for investors. As the name implies, return on assets (ROA) measures how efficiently a company can squeeze profit from its assets, regardless of size. In this article, we’ll discuss how a high ROA is a tell-tale sign of solid financial and operational performance.

Key Takeaways

  • Return on assets (ROA) is an indicator of how profitable a company is relative to its assets or the resources it owns or controls.
  • Investors can use ROA to find good stock opportunities because the percentage shows how efficient a company is at using its assets to generate profits.
  • An ROA that rises over time indicates the company is doing a good job of increasing its profits with each investment dollar it spends.
  • A falling ROA indicates the company might have over-invested in assets that have failed to produce revenue growth, a sign the company may be trouble.

Calculating Return on Assets (ROA)

The simplest way to determine ROA is to take net income reported for a period and divide that by total assets. To get total assets, calculate the average of the beginning and ending asset values for the same time period.

Return on Assets (ROA) = Net Income/Total Assets

Some analysts take earnings before interest and taxation (EBIT) and divide by total assets:

Return on Assets (ROA) = EBIT/Total Assets

This is a pure measure of the efficiency of a company in generating returns from its assets without being affected by management financing decisions.

What Is a Good ROA?

Whichever method you use, the result is reported as a percentage rate of return. A return on assets of 20% means that the company produces $1 of profit for every $5 it has invested in its assets. You can see that ROA gives a quick indication of whether the business is continuing to earn an increasing profit on each dollar of investment. Investors expect that good management will strive to increase the ROA—to extract a greater profit from every dollar of assets at its disposal.

A falling ROA is a sure sign of trouble around the corner, especially for growth companies. Striving for sales growth often means major upfront investments in assets, including accounts receivables, inventories, production equipment, and facilities. A decline in demand can leave an organization high and dry and over-invested in assets it cannot sell to pay its bills. The result can be a financial disaster.

The higher the ROA percentage, the better, because it indicates a company is good at converting its investments into profits.

ROA Hurdles

Expressed as a percentage, ROA identifies the rate of return needed to determine whether investing in a company makes sense. Measured against common hurdle rates like the interest rate on debt and cost of capital, ROA tells investors whether the company’s performance stacks up.

For example, investors can compare ROA to the interest rates companies pay on their debts. If a company is squeezing out less from its investments than what it’s paying to finance those investments, that’s not a positive sign. By contrast, an ROA that is better than the cost of debt means that the company is pocketing the difference.

Similarly, investors can weigh ROA against the company’s cost of capital to get a sense of realized returns on the company’s growth plans. A company that embarks on expansions or acquisitions that create shareholder value should achieve an ROA that exceeds the costs of capital. Otherwise, those projects are likely not worth pursuing. Moreover, it’s important that investors ask how a company’s ROA compares to those of its competitors and to the industry average.

Getting Behind ROA

There is another, much more informative way to calculate ROA. If we treat ROA as a ratio of net profits over total assets, two telling factors determine the final figure: net profit margin (net income divided by revenue) and asset turnover (revenues divided by average total assets).

If the return on assets is increasing, then either net income is increasing or the average total assets are decreasing.

Return on Assets (ROA) = (Net Income/Revenue) X (Revenues/Average Total Assets)

A company can arrive at a high ROA either by boosting its profit margin or, more efficiently, by using its assets to increase sales. Say a company has an ROA of 24%. Investors can determine whether that ROA is driven by, say, a profit margin of 6% and asset turnover of four times, or a profit margin of 12% and an asset turnover of two times. By knowing what’s typical in the company’s industry, investors can determine whether or not a company is performing up to par.

This also helps clarify the different strategic paths companies may pursue—whether to become a low-margin, high-volume producer or a high-margin, low-volume competitor.

Return on Assets (ROA) vs. Return on Equity (ROE)

ROA also resolves a major shortcoming of return on equity (ROE). ROE is arguably the most widely used profitability metric, but many investors quickly recognize that it doesn’t tell you if a company has excessive debt or is using debt to drive returns.

Investors can get around that conundrum by using ROA instead. The ROA denominator—total assets—includes liabilities like debt (remember total assets = liabilities + shareholder equity). Consequently, everything else being equal, the lower the debt, the higher the ROA.

Special Considerations

Still, ROA is far from being the ideal investment evaluation tool. There are a couple of reasons why it can’t always be trusted. For starters, the “return” numerator of net income is suspect (as always), given the deficiencies of accrual-based earnings and the use of managed earnings.

Also, since the assets in question are the sort of assets that are valued on the balance sheet (namely, fixed assets, not intangible assets like people or ideas), ROA is not always useful for comparing one company against another. Some companies are “lighter,” with their value based on things such as trademarks, brand names, and patents, which accounting rules don’t recognize as assets.

A software maker, for instance, will have far fewer assets on the balance sheet than a car maker. As a result, the software company’s assets will be understated, and its ROA may get a questionable boost.

The Bottom Line

ROA gives investors a reliable picture of management’s ability to pull profits from the assets and projects into which it chooses to invest. The metric also provides a good line of sight into net margins and asset turnover, two key performance drivers. ROA makes the job of fundamental analysis easier, helping investors recognize good stock opportunities and minimizing the likelihood of unpleasant surprises.