The term Return on Assets (ROA) refers to a financial ratio that indicates how profitable a company is in relation to its total assets. Corporate management, analysts, and investors use ROA to determine how efficiently a company uses its assets to generate a profit.
Key Insights
- ROA as a Profitability Metric: Return on assets is a metric that indicates a company’s profitability in relation to its total assets.
- Efficiency Indicator: It helps management, analysts, and investors determine whether a company uses its assets efficiently to generate a profit.
- Calculation: ROA is calculated by dividing a company’s net income by its total assets.
- Comparison Across Industries: For meaningful insights, compare ROA of companies within the same industry.
- Impact of Debt: ROA factors in a company’s debt, unlike return on equity.
Understanding Return on Assets (ROA)
The ROA metric is commonly expressed as a percentage using a company’s net income and its average assets. A higher ROA signifies a company’s efficiency and productivity in managing its balance sheet to generate profits, whereas a lower ROA indicates room for improvement.
Comparing profits to revenue is a useful operational metric, but comparing profits to the resources a company used to earn them displays the feasibility of that company’s existence. Return on assets is the simplest of such corporate bang-for-the-buck measures. It tells you what earnings are generated from invested capital or assets.
ROA for public companies can vary significantly, and it is highly reliant on the industry in which they operate. As a result, ROA should be compared between similar companies for accurate assessment.
Calculating ROA
ROA is calculated by dividing a company’s net income by its total assets. The formula is:
ROA = ( \frac{Net\ Income}{Total\ Assets} )
Let’s illustrate with an example:
Assume Sam and Milan both start hot dog stands. Sam spends $1,500 on a simple cart, while Milan spends $15,000 on a themed unit.
If Sam earns $150 and Milan earns $1,200, Milan’s business is more valuable but Sam’s is more efficient. Sam’s ROA is $150/$1,500 = 10%, while Milan’s ROA is $1,200/$15,000 = 8%.
Important Considerations
Due to the balance sheet accounting equation, total assets are the sum of total liabilities and shareholder equity. Because total assets include both debt and equity, some analysts adjust ROA by adding back interest expense to the formula.
In other words, the impact of debt is negated by adding the cost of borrowing back into the net income. This refined ROA considers the cost of debt more deeply, making it particularly insightful for highly leveraged firms.
ROA shouldn’t be the sole metric in making investment decisions; it is one of many measures to assess a company’s profitability.
ROA vs. Return on Equity (ROE)
Both ROA and Return on Equity (ROE) measure how well a company utilizes its resources, but they view debt differently.
- ROA: Accounts for the company’s debt since total assets include borrowed capital.
- ROE: Only measures returns on equity, excluding liabilities. This means that as a company takes on more debt, ROE becomes higher relative to ROA, assuming returns are constant.
Limitations of ROA
One significant limitation of ROA is that it can’t be universally applied across industries due to differing asset bases. Companies in industries such as oil and gas will have vastly different asset structures compared to those in retail.
Analysts view ROA as particularly useful for banks because bank balance sheets represent asset and liability values more accurately via mark-to-market accounting.
Example of ROA
Consider the ROA for three companies in the retail industry:
| Company | Net Income | Total Assets | ROA |
|---|---|---|---|
| Macy’s | $1.7 billion | $20.4 billion | 8.3% |
| Kohl’s | $996 million | $14.1 billion | 7.1% |
| Dillard’s | $243 million | $3.9 billion | 6.2% |
Macy’s generated 8.3 cents of net income per dollar of assets, which was more efficient than both Kohl’s and Dillard’s. Efficient asset management is crucial, showing Macy’s management was more adept during this period.
How Is ROA Used by Investors?
Investors use ROA to evaluate stock opportunities. A rising ROA suggests the company is efficiently increasing its profits relative to investments. Conversely, a declining ROA may indicate problematic over-investment.
What Is Considered a Good ROA?
A ROA above 5% is generally good, while above 20% is considered excellent. However, ROAs should always be compared among firms in the same sector. For example, comparing a software company to an automaker may lead to misleading conclusions.
Related Terms: Return on Equity, Net Income, Assets, Financial Ratios, Investment.
