Summary - Balance sheets and income statements are two financial statements that allow investors to evaluate a company’s financial health. One way they do this is by providing the data needed to calculate financial ratios. There are ratios that help assess a company’s liquidity, activity, solvency, and profitability. This article is going to take a closer look at profitability ratios, specifically the return on assets (ROA) ratio.
To calculate a company’s return on assets, an investor needs two pieces of information. First, they need a company’s net income (also called “net profit after taxes”) over a period of time, which is typically 12 months or a fiscal year. This can be found on the bottom line of their income statement. The second piece of information they need is their total assets for the same period being measured. An asset is defined as anything owned by the business that has economic value. Assets are divided into short- and long-term assets on a company’s balance sheet. Typical asset categories include cash, marketable securities, accounts receivable, prepaid expenses, inventory, fixed assets, intangible assets, goodwill, and other assets. Unlike some other ratios, the ROA ratio looks at total assets, not just short-term or long-term.
The return on assets formula is: net income/average assets.
It can also be: net income/end of period assets
In some cases, analysts may choose to include interest expenses with net income to help offset the impact of any debt the company takes on. When this is the case, the formula becomes:
ROA = (net income + interest expense)/average assets
The ROA ratio is important for several reasons:
- It is a measure of a company’s profitability and efficiency – the higher the ROA, the more profitable and efficient a company is with their capital assets.
- It allows investors to compare the performance of companies across industries.
- It can show investors if a company is asset-intensive or asset-light
In theory, the more money (i.e. revenue) a business generates, the more profitable it should be. However, there are many examples where this is not the case. Companies can generate significant revenue, but not be profitable. And even if they are profitable, there may be other companies within their industry that generate a higher percentage of profits despite not having either the amount of revenue or total assets that a different company may have. This is why it’s important to understand the significance of ratios and where they fit into the fundamental analysis of a company and its stock.
While some ratios, such as the price-to-sales ratio may give you a good idea of how accurate a company’s current stock is valued, there are other questions that investors can look at from a fundamental perspective. One of those questions is how efficient is the company at generating profit in relation to its total assets. To calculate this, investors can use a ratio called return on assets (ROA).
In this article, we’ll review what the return on assets ratio is, what the formula is to calculate it and where that information comes from. We’ll also review what the ROA ratio may say about the financial health of a company that will be important for investors to understand.
What is the return on assets (ROA) ratio?
The return on assets (ROA) ratio is one of several profitability measures that investors use to measure their return on investment (ROI). The ROA ratio is a measurement, expressed as a percentage, of how profitable a business is in relation to their total assets. The ROA ratio is typically calculated over a 12-month period that may be aligned with a company’s fiscal year.
What is the return on assets formula?
The formula for ROA is as follows:
ROA = Net Income/Average Assets
An alternate formula can be used when using assets for just the end of a period
ROA = Net Income/End of Period Assets
Net Income– this is the total of a company’s revenue for a given period of time minus the cost of goods sold (COGS) and other expenses such as rent, payroll, equipment, advertising, and taxes. This is found on a company’s income statement. Net income is not the same as retained earnings which is found on a company’s balance sheet. Net income includes any dividends that the company paid to shareholders. That dividend cost will be deducted from net income before posting as retained earnings on the balance sheet.
Average Assets– this is a simple average that is calculated by adding the amount of assets a company had at the beginning of the measuring period with the total assets at the end of the period, then dividing by two. For example, the ABC Company started its fiscal year with $350,000 in total assets and ended the year with $370,000 total assets. Its average assets would be:
350,000 + 370,000 = 720,000
720,000/2 = 360,000
Company ABC’s average assets for the period would be $360,000.
Analysts frequently choose to use average assets instead of the end of period assets because a company’s assets may fluctuate over time for many reasons such as purchases or sales of equipment, seasonal sales, or changes in inventory. Using the average is an attempt to smooth out these fluctuations to get a more accurate picture of a company’s total asset base.
Let’s put it all together with an example:
The ROA ratio for each company would be:
Company X – 0.25 (25%) – Company X generated 25 cents in profit for every dollar in assets.
Company Y – 0.62 (62%) – Company Y generated 62 cents in profit for every dollar in assets.
Company Z – 0.37 (37%) – Company Z generated 37 cents of profits for every dollar in assets.
There is one variation on this formula and that occurs when a company adds interest expense to net income. This is done to negate of taking on any borrowing that was done by adding back the cost of borrowing. When this is done, the formula simply changes to:
ROA = (Net Income + Interest Expense)/Average Total Assets
Another variation on the formula takes into account earnings before interest and taxes (EBIT). In this case, the formula is:
ROA = EBIT/Average Total Assets
Why is the ROA ratio important?
The percentage produced by the ROA ratio is an indicator of how efficiently a company is performing. It is a comparison of their profit to the capital it has invested in their assets. A high or growing number is a sign of more productivity and efficiency in terms of how the company is using their resources. A business can improve their ROA by generating more profits from fewer assets. One way for this to happen is when companies make improvements in inventory and order control through supply chain management. In contrast, a declining ROA is more often than not a sign of trouble. This is particularly true for stocks of growth companies. These companies generally need to make significant investments in infrastructure which will increase their total assets. If they experience a decline in sales (revenue), they will be challenged to keep up with the cost of financing their additional assets.
However, as with other ratios, investors will only get value out of the ROA ratio if they use it to compare a single company’s performance over several periods of time, and if they’re comparing one company to another it’s critical that those companies be in the same industry.
When looking at a single company, there can be many reasons for income to change from year to year. If an investor assigns too much value to a single year, good or bad, it can cause them to misjudge a company’s financial strength or weakness. But even when an investor is confident in his evaluation of a company, the ROA should be compared to other competitors within their industry. This is because different industries use assets differently. Banks, for example, will have far fewer capital intensive assets as opposed to a construction company.
The return on assets ratio is sometimes confused with the asset turnover ratio. Both are ways for investors to calculate return on assets, but there are distinct differences. On a balance sheet, total assets are balanced by liabilities and shareholders’ equity. This means that by understanding total assets, investors can understand how those assets relate to a company’s debt and equity structure. With that in mind, ROA is about calculating how the return in profit for each dollar invested in assets. The asset turnover ratio, on the other hand, measures the amount of sales that are generated from every dollar invested in total assets.
Checks and balances to use with the ROA ratio
Like most forms of fundamental analysis, the ROA ratio should not be used as a standalone metric. A company’s ROA ratio can be measured against the interest rate that a company pays on its debt and cost of capital. If the company is not getting as much profit from their investments as they are paying to finance those investments, it is not a positive sign. The opposite is also true – and it means the company is turning their debt into profit.
The ROA ratio can also be used to assess the value of pursuing expansions or acquisitions. In theory, such activity should generate shareholder value in the form of an ROA ratio that exceeds the additional cost of capital.
Limitations of the ROA ratio
There are two basic limitations that investors need to be aware of when using the ROA ratio. The first limitation is the “return” numerator used to calculate net income can be suspect because companies use accrual-based earnings or managed earnings. The second limitation is what constitutes an asset. For example, because the ROA formula includes both short- and long-term assets it means that intangible assets (trademarks, patents, brand names) can be included. These assets, however, are not recognized as assets using traditional accounting rules. This means that a company that relies on these intangibles may report fewer assets and their ROA will be artificially higher, but may not reflect their ability to use profits from assets.
The final word on the return on assets (ROA) ratio
Using the ROA ratio can be a good way for investors to compare the profitability of one company over multiple quarters and/or years. It is also a useful comparison ratio between two similar companies.
However, when using the ROA ratio as a way to compare two or more companies, it is critical that the companies be both a similar size and reside in the same industry. Financial services companies, such as banks, for example, have huge balance sheets with a list of assets that include loans, cash, and investments. Their total assets could easily total over a trillion dollars, but their net income may only be a fraction of that. This means their ROA ratio may be lower when compared to a company in a different industry but may be perfectly in line, or even higher than, other banks.
Another reason investors need to ensure they are looking at companies in the same industry is that companies use assets in different ways. Some industries such as manufacturing are asset-heavy. They require large facilities and heavy investments in equipment and logistics. In contrast, a company that writes software will not generate as many profits, but are asset-light. This means that compared to an automobile manufacturer, the software company will most likely have a higher ROA ratio. But that is only meaningful if it is compared to another company within its industry.