The return on assets ratio (ROA), also referred to as the return on total assets, is a productivity ratio measuring the net income made by a company’s total assets at a given time frame. In short, the ROA or the return on assets measures how a company’s assets can be managed to gain profit over a given period.
The return on assets ratio is given as a percentage. The higher the percentage, the more effective a company’s management is in generating profits by managing its balance sheet. Since the purpose of a company’s assets is to generate revenue, the ratio is useful to both the investors and the management in gauging how well the company can generate profits from its investments in assets. ROA can also be considered a return on investment as most companies’ most significant investments are informed from capital assets. Thus, companies invest in capital assets, and the gains are quantified as profits. Therefore, this ratio measures the profitability of a company’s assets.
The ROA Formula
Return on investment is calculated by taking the business’s net income and dividing it by its total assets. The net income is the amount that the business is left with after deducting all the business expenses. The total assets are contained in the business balance sheet.
Return on assets (ROA) = Net Income/ Average Total Assets
Let’s take the example of two companies.
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Company A has a net income of $6.3 million in 2019 and $3.6 million in 2018. Total assets from the balance sheet read $70 million in 2019 and $60 million in 2018.
Return on assets for company A = 6.3 / 70
= 9% in 2019
Return on assets for company B = 3.6/60
=6% in 2018
From the above example, it is concluded that the company’s management is doing well at managing its assets to make a profit. That is because the ROA was 9% in 2019 and 6% in 2018. A high return on assets is a good indicator.
Characteristics of a Good Return on Asset Ratio
A good return on assets ratio shows that a company is effective in the management of its assets. A company with a good ROA should be within the range of its peer companies. If an industry has an average ROA of 15% and a company has a ROA of 15.7, it is assumed to manage its assets well in relation to the industry.
However, if a company has a ROA that is much higher than the average of its peer companies, for example, 20% compared to the average 15%, it could mean either of two scenarios.
The company does not own many assets. Instead, they borrow or lease extra assets. ROA takes into account only the assets owned. Companies with fewer assets have a high ROA. The company can manage its assets better to gain more income. Management and earnings capabilities are essential factors, as well as the method used by companies to finance their assets.
Importance of ROA
It is important to measure a company’s profitability. This shows how well a company utilizes assets to make a profit. The ratio is mostly used when comparing two peer companies of the same size in a similar industry or a company’s performance between different times. They are used internally to trace the use of assets over time, look into the company’s performance concerning their industry, or compare two different divisions or operations. ROA can tell if assets are under-utilized or if they are effectively used to generate profit.
The ROA ratio can also be used internally to evaluate the benefits of expanding an existing operation or investing in a new system. The best choice should increase income and productivity and reduce assets’ cost.
Limitation of ROA
ROA cannot be used to compare companies across industries. Companies in different sectors have diverse asset footings. For instance, a technology company will own software, whereas manufacturing companies will hold many more assets such as shipping containers and warehouses.
All internal and external factors should be included, and consider the competitors, ROA of industry, and market demand while analyzing and interpreting using ROA. Other internal factors that have a significant impact on ROA include changing and replacing the accounting policies and using old assets.