Return on assets (ROA) is a measure of the profit a company or property makes relative to its assets or costs. Return on assets shows investors or analysts how efficiently a company uses its assets to generate income. ROA is ratio, usually shown as a percentage. The higher it is, the better. A high ROA shows efficient use of a company’s resources, a low ROA signifies inefficient use of resources.
For a business to thrive, it has to manage resources efficiently. The company’s profit relative to its revenue is one way of assessing this quality. However, the return on assets is a more comprehensive measure that depicts the company’s use of all the resources at its disposal.
So how is ROA calculated?
To calculate the company’s ROA , take the following step
Here’s the ROA equation:
Return on Assets = Net Income/Total Assets
Net income can also be expressed as profit. Also, some analysts prefer to use average assets instead of total assets, but the basic concept is the same.
A higher ROA is an indication of higher asset efficiency. For example, consider Tom and Jerry, two brothers who bought properties in different locations. Tom had limited resources and bought a small multifamily building that cost $200,000. Jerry, on the other hand, was able to afford a larger mutifamily building in a prime location that cost him $2M. Both of them rented their properties out. In a month, Tom’s net income was $10,200 while Jerry’s net income (total profits) was $40,000. Although Tom made less money than Jerry, but his return on assets is higher and his property is more efficient.
Using the ROA formula,
Tom’s ROA is $10,200/$200,000 = 6%.
Jerry’s ROA is $40,000/$2M = 2%
Even though Jerry had a better and more attractive space and seemed to earn more than Tom, Tom’s property was more efficient.
What will you consider a wise investment? No doubt it is one where the capital invested or asset is generating the expected income, even generating more in some cases. However, the ROA is not always fixed; certain factors may affect how much return an investor receives. For public companies, ROA will be greatly affected by what they produce or the services they render. Experts recommend you compare a property’s figure against the previous year, or with other properties of a similar type when calculating ROA.
This way a property investor can easily understand what needs to be done to further convert investments into profits. As a general rule, a higher ROA indicates that a property or investment makes more money from fewer investments.
Every financial department keeps track of investments using the balance sheet. On this sheet, a company’s total assets include all liabilities (debt) and equities. The operations of a company can be funded using any of these types of financing. To make up for this, the costs of assets have been disregarded in calculating ROA, thus paving the way for the addition of interest expense Sounds awkward? Simply stated, the cost of borrowing (toward the net income) eliminates the negative impact of liabilities. Because the interest expense has been excluded in preparing the financial statement, the interest expense is added back to make up for this void. In calculating the ROA, the ‘average assets’ become the denominator in the formula instead of the ‘total assets.’
Because various companies use assets in different ways, it makes sense that companies within the same industry are compared against each other when calculating the ROA. That is why we can expect the ROA for firms that offer services (like banks) to be higher than the ROA for construction companies because they are capital intensive.
Here is a case study of the ROA for three real estate companies in the telecommunications company:
Assuming that for a period of 12 months, the following financial data was collected
Telecommunications Stocks
NameNet Income (Profit)Net AssetsReturn on Assets (ROA)ABC$2 billion$35.2 billion5.6%Safe Homes$1.3 billion$20.4 billion6.3%Tradeable$ 900 million$7.5 billion12%
From the table, it is clear that Tradeable is making the best use of its funds compared to the others. With this information, the management of each company can re-strategize and figure out new ways to better use available resources to increase their ROA value over the next 12 months.
How a company makes the best use of available resources (assets) can be ascertained using both ROA and ROE. A major limitation of Return on Equity is that it only takes a company’s equities into cognizance, but liabilities are disregarded. So, while ROA takes debts and other liabilities into account, ROE does not.
Almost every company takes on more debt at some point. Once this happens, the ROE is expected to be high, while the ROA will inversely drop. And as long as money still comes in, the company’s assets will increase. If returns don’t drop and the company’s assets remain higher than the equity, the ROA’s calculation will be affected because the denominator of the formula (the assets) will remain higher. The ROA will thus reduce while the ROE remains constant.
Because various companies own and operate different types of assets (like Real Estate and Telecommunications firms), ROA cannot be used across multiple industries. This is the biggest limitation of ROA.
Another issue pointed out by some experts is that application of the formula for calculating ROA is limited. They argue that it is better suited for financial institutions like banks because the balance sheets have already factored in the assets, liabilities, interest expense and interest income.
Return on assets (ROA) is an investor or a company indicator that they are making the best use of the available resources (assets). It helps them understand if they are efficient and making profits as they should, taking into consideration the assets. This value also helps them to plan and make the best investment decisions.
Since ROA shows investors which companies are generating enough profits over a period of time, investors can easily use this to measure which stock to take advantage of.
For instance, if a company’s ROA increases over time, it is a sign that the company is making profits consistently. An investor may decide to invest some funds in the company’s stocks. On the other hand, if during the same period a company’s ROA keeps falling, it shows clearly that there is little or no revenue growth. A wise investor will steer clear.
In summary, ROA helps investors compare the efficiency of various companies within the same industry to figure out which one has good investment prospects.
To calculate the ROA, determine your company’s net income and average assets. Then divide the net income by the average assets. The ROA is always expressed as a percentage.
To get your company’s net income, check the bottom of your company’s statement of income. You can easily find your total assets on your balance sheet. Be sure you calculate the average assets because, with time, a company’s assets may vary. To ensure your ROA value will be accurate, using the average asset is more reliable than using the total asset.
Note that this is not the only way to calculate ROA.
A ROA value less than 5% is considered bad for business. Any value above 5% is good, while any value above 20% is awesome.
