Return on Assets (ROA) Definition, Formula & Calculation
When reviewing the financial health of a business, there are many financial ratios that analysts can use. One of these ratios is the return on assets, or ROA. ROA measures efficiency, which is very important in business. After all, businesses are all about doing things efficiently. This article is going to cover ROA, its formula and calculation, and how it’s used.
Table of Contents
KEY TAKEAWAYS
- Financial analysts and investors use many different financial ratios to determine a company’s success. One of the most useful, as well as the simplest, is return on assets (ROA).
- ROA describes how efficiently a company turns assets into income.
- The higher the number, the more a company makes for each dollar spent on assets.
What Is Return on Assets (ROA)?
Return on assets is one of many financial ratios used to determine a business’s financial performance. Specifically, it is a profitability ratio. This metric determines how efficiently a company is using its assets to generate a profit over a period of time.
An In-Depth Look at ROA
Like ROI (Return on Investments), ROA is a very simple metric. However, it is arguably more useful. Return on Assets can compare a company’s profits to the assets that financial assets used to make them. To simplify, it tells you what money gets generated from invested capital or assets.
When investors and analysts look at ROA, they have to take into consideration the industry. The rate of return on asset ratio for the retail industry is going to be different from the auto industry. While this may be true, it can compare companies that are in the same industry. ROA can serve as a comparative measure, but only in specific instances. Again, you can use it against similar companies. Perhaps more useful, though, is using it to compare a company to itself.
ROA is a simple formula, which will get covered below. Before that, though, it’s important to know what you’re looking for. Companies want to see a higher ROA figure. The higher the number, the better. When a ROA ratio is high, it means that the company is making more profit for every dollar of assets spent. This translates to having to invest less in assets to make more money.
Return on Assets Formula
Of the financial ratios that analysts use, the ROA formula may be the simplest. You only need two pieces of information. You need a company’s net income and their total assets. Net income is on the income statement, while total assets are on a company’s balance sheets. Once you have that information, you’re ready to plug it into the formula below.
It’s as simple as that. Because it is a ratio, it is a decimal point or a percentage. Again, a higher number means that a business is making more profits for every dollar put into assets.
An Example of the ROA Formula in Action
Let’s take a look at two different companies. Company A invests $2,000 into assets for their business. Company B invests $25,000. The assets of Company A are simple, but they work well. Company B invested more money in order to upgrade the same assets. Let’s assume that this is the only money put into assets by each company.
Company A makes $400 in profit. Company B makes $2,000. At first glance, it looks like Company B is more efficient than Company A. They made more money, after all. However, if we look at the ROA formula, we’ll find different results.
Company A
ROA = $400 / $2,000
ROA = .20 or 20%
Company B
ROA = $2,000 / $25,000
ROA = .08 or 8%
After calculating ROA, we find that Company A is far more efficient. This is because for every dollar in assets invested, they were able to get a return of 20%. Company B is worth more but is less efficient. They only received a return of 8% for every investment dollar.
Things to Consider
While ROA is simple to calculate, it doesn’t provide a full picture. Most financial ratios don’t. As such, it’s important to realize that total assets per the balance sheet include total liabilities and shareholder equity.
Both of these are types of financing that companies use to finance operations. Because of this, some investors and financial institutions disregard the cost of securing funds. This requires the interest expenses to be added back to the total net income.
To put it simply, adding interest back to the net income reduces the impact of paying for loans. Some analysts argue that this gives a clearer idea of how much money a company is truly making. Adding interest expense back to the net income increases the ROA ratio in all cases.
Comparing Return on Assets to Return on Equity
Another financial ratio that measures a company’s efficiency is return on equity (ROE). There is a major difference between the two ratios, however. ROA considers how leveraged a company is. This means it looks at how much debt a company has at any given time. This is because a company’s total assets include any capital that it has borrowed to operate.
ROE does not consider a company’s liabilities. This means that it is only looking at a rate of return on equity or how much a company is worth. Should a company take out large sums of loans, its ROE is going to be higher than its ROA. That is because ROE excludes a company’s liabilities, which include loan debt. In some cases, a company’s ROA can drop while its ROE stays the same. This makes ROA a more reliable measure of efficiency for a company most of the time.
For the most part, a company wants its industry average assets to stay about the same and they want net income to rise. This indicates that the company is operating more efficiently.
Issues with ROA
While ROA is a great financial ratio, there are some inherent issues with it. The largest issue among analysts and investors is that it can’t be used across industries. Companies in different industries are going to have different asset bases from each other. This means that the amount of money invested in assets differs from industry to industry. The asset bases of software companies are going to be very different from the asset bases of auto manufacturers.
Additionally, in interviews with industry experts, some analysts have stated that ROA is even more limited. Many believe that ROA is most suitable for financial institutions. That’s because the balance sheets of these organizations are different from any other industry. They factor in interest expense and interest income to start.
How Investors Use ROA
Investors use ROA to find the best stock opportunities from public companies. They do this using ROA because this ratio shows how efficiently a company can generate income from its assets. This means that, in most cases, more money invested means a higher income. Investors look for companies that have an ROA that consistently rises over time.
Summary
As a business owner, your ROA tells you a lot about your success. It’s important that you use this metric to see where you need to improve. What’s more, ROA can show investors which companies to invest in and more. Use ROA to your advantage and grow your business to new heights.
Frequently Asked Questions About Return on Assets
Unfortunately, this question is dependent upon the industry in question. The asset base of each industry is unique to itself. This means that some industries are going to have a high ROA naturally, while others will be low. That said, generally speaking, a 5% ROA is good, and 20% is excellent.
Most analysts will tell you that ROA is a better measure of a company’s performance. This is because ROE does not take a company’s liabilities into consideration. This can inflate the Return on Assets ratio quite a bit.
Industries with a high average ROA include tobacco, computer software, social media, and grocery stores.
A high ROA indicates that a company is generating a lot of profit from its assets. A low ROA indicates that the company is not using its assets as efficiently as it could be. The higher the ROA, the higher the ROE will be.
There are a number of ways to improve return on assets. One way is to increase sales without increasing costs. Another way is to decrease costs without decreasing sales. Finally, you can do both of these things simultaneously.
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