Return on Assets

Return On Assets (ROA) refers to the financial calculation that helps measure how efficiently a company uses its assets to gain profits. It is the ratio between net income and total average assets, to analyze how much returns a company is producing on the total investment made in the company.

ROA is the metric that helps assess profitability of an organization and it is represented in percentage form. When this ratio is high, it indicates a company’s efficient handling of the assets to generate good profits. On the contrary, a lower ROA would mean a company needs to improve at asset handling for profits.

Return on Assets is a metric that helps businesses check how well they utilize their total assets to reap maximum profits. It is calculated as the ratio between the net income and the total average assets. While Net income represents the amount of financial and operational income a company has got during a financial year, total average assets is the arithmetic average of total assets a company holds. The value obtained helps investors to make better investment decisions, while guiding the management to identify rooms for improvement and make wiser business decisions.

Let us take an example of General Motors and Ford, two aces of the automobile industry. The Return on Assets of General Motors (5.21%) is greater than that of Ford (3.40%) for FY2016. This figure relates to the firm’s earnings to all capital invested in the business. In this article, we will discuss Return on Assets in detail.

Understanding how much revenue one firm would earn by employing its assets is not a good measure. So there should be something more refined. And the refinement has been done in Return on Assets ratio.

When one calculates the asset turnover ratio, we consider the net sales or the net revenue. However, revenue is not always a good predictor of success. For example, many organizations earn good revenue, but there would hardly be any profit compared to the expenses they need to bear. So comparing net revenue with the total assets wouldn’t solve the issue of the investors that want to invest in the company.

Let us now look into another example of Box Inc. and its Asset Turnover Ratio. Unfortunately, this asset turnover doesn’t tell us much about the performance of Box Inc.

source: ycharts

However, when one looks at the Return on Assets Ratio of Box Inc, it can be seen that it has been negative. It implies that the company cannot generate returns concerning its deployed capital.

Though the ROA calculation guides businesses and helps them learn about the extent to which they use their assets efficiently for profits, it cannot be the only metric to be used. A business should not rely solely on the ROA. It should rather be considered collectively with other ratios that help assess profitability of a business in different ways. Such other ratios include Return on Equity, Return on Invested Capital, Current Ratio, Quick Ratio, Du Pont Analysis, et

Let us have a look at its formula.

Return on Assets Formula = EBIT / Average Total Assets

There are diverse opinions on what to take in the numerator of this ratio! Some prefer to take net income as the numerator, and others like to put EBIT where they don’t want to consider the interests and taxes.

• Here, considering EBIT is recommended as this term is before interest and taxes (pre-debt and pre-equity).
• Likewise, when comparing it with the denominator, i.e., Total Assets, we are taking care of both the Equity and Debtholders.
• Net Income / Average Total Assets may be an incorrect comparison due to its numerator. Net income is the return attributed to the equity holders, and the denominator – Total Assets considers both Equity and Debt. It means we are comparing apples to oranges:-

Let’s talk about the average total assets. What will you consider while computing a figure of average total assets? We will include everything capable of yielding value for the owner for more than one year. That means we will include all fixed assets. At the same time, we will also include assets that can easily be converted into cash. That means we would be able to take current assets under total assets. And we will also include intangible assets that have value, but they are non-physical, like goodwill. We will not take fictitious assets (e.g., promotional expenses of a business, discount allowed on the issue of shares, a loss incurred on the issue of debentures, etc.) into account. Then we would take the figure at the beginning of the year and the end of the year and `.find an average of the total figure.

EBIT is considered for calculating Return on Assets Ratio because this would give a holistic picture of the company. And thus, the interpretation of the ratio would be much more holistic.

• Let’s say that the investors find out that the ROA of a company has been more than 20% for the last five years. Do you think it’s a good measure to invest in the company for future benefits? The answer is, of course, yes! It’s far better to invest in a stable company than one that produces volatile profits over the years.
• In simple terms, we can say that increase in the ROA means better use of assets to generate returns for the firm, and its decrease means that the firm has room for improvement – maybe the firm needs to reduce a few expenses or replace a few old assets that are eating out the profits of the company.

Let us consider the following instances to understand the return on assets meaning and its working better:

Example 1

Let’s do the calculation to find out the Return on Assets for both the companies.

First, as we have been given Operating Profit and Taxes, we need to calculate the Net Income for both companies.

And as we have the assets at the beginning of the year and the end of the year, we need to find out the average assets for both companies.

Now, let's calculate the ROA for both companies.

For Company A, the ROA is 75%. 75% is a great indicator of success. And if Company A has been generating profits in the range of 40-50%, then investors may easily put their money into the company. However, before investing anything, the investors should cross-check the figures with their annual report and see whether there is an exception or any special point is mentioned or not.

For Company B also, the ROA is quite good, i.e., 53%. Usually, when a firm achieves 20% or above, it is considered healthy. And more than 40% means the firm is doing quite well.

Example 2

Now let’s understand the ratio from a practical standpoint. Below is the snapshot of Colgate’s Balance Sheet.

Below is the snapshot of Colgate's Income Statement. Please note that we need to use EBIT for the Return on Total Assets calculation.

Let us now calculate the ROA of Colgate.

Colgate’s Return On Assets Ratio = EBIT / Average total assets

Colgate’s Return on total assets has been declining since 2010. Most recently, it declined to its lowest to 21.9%. Why?

Let’s investigate…

Primarily, two reasons contribute to the decrease – either the denominator, i.e., average assets have increased significantly, or the Numerator Net Sales have dropped significantly.

In Colgate, we note that the total assets decreased in 2015. The decrease in total assets should ideally lead to an increase in the ROTA ratio.

It leaves us to look at the Net Sales figure. From the management discussion and analysis section of Colgate, we note that the overall Net sales decreased by as 7% in 2015.

This decrease in Sales by 7% led to a decrease in Return on Assets.

The primary reason for the decrease in sales was the negative impact due to foreign exchange of 11.5%.

Organic sales of Colgate, however, increased by 5% in 2015.

In this section, first, we will look at a few banks and their Return on Total Retail Assets to conclude how good they are doing in terms of generating profit.

source: ycharts

From the above graph, we can now compare the ROA of the top global banks.

Wells Fargo of 1.32% has generated the highest ROA, and the lowest return on assets ratio has been generated by Mitsubishi UFJ Financials of 0.27%. All other banks’ returns on total assets are between 0.3%-1.3%.

To understand where these banks stand in terms of comparison, we can take an average and compare each bank’s performance. We have taken each bank’s ROA, and the average ROA is 0.90%. That means many banks that are performing over 0.9% are doing good.

The Return on Asset is an important metric, which helps internal and external stakeholders make wiser decisions. The significance of the ROAs have been listed point-wise below:

• It helps users to compare the performance of the companies between over a period or make comparisons between the companies that are of same size and industry.
• The companies that believe in building or stocking fixed assets, the ROA is lower for those companies. This is because the total assets, when large in number, increases the denominator of the calculation.
• However, there are companies that has large asset base but still it can have large ROA if the net income is too high.
• When the ROA is high, it helps investors know that the profitability of the firm is more and hence better for them to invest in. In addition, the lower ROA indicates investors should not invest in the firm and lets the businesses learn about the loopholes, after which they plan strategies to better the profitability of the firm.

Undoubtedly, ROAs are important in many ways, but there are a few limitations, which one must be aware of:

• If one considers Net Income to calculate the ratio, then the picture wouldn’t be holistic as it includes Taxes and Interests (if any). But in the case of EBIT in number, we don’t need to worry about that.
• Industries that are asset intensive won’t generate that much income compared to the industries which are not asset intensive. For example, if we consider an auto industry, to produce auto and, as a result of that, profits, the industry first needs to invest a lot in the assets. Thus, in the case of the auto industry, the ROA won’t be that higher.
• However, in the case of services companies where investments in Assets are minimal, the ROA will be pretty high.

This article has been a guide to what is Return on Assets. Here, we explain the concept along with its formula, interpretation, significance, examples, and limitations. You may also have a look at the following articles to explore more topics related to the concept.

• Tangible Assets Examples
• PEG Ratio Meaning
• Price to Book Value
• What is Working Capital Ratio?