Table of Contents:
- What is ROA?
- Understanding return on asset (ROA) ratios
- Return on assets formula
- ROA vs. ROE
- ROA considerations for investors
- ROA limitations
- The bottom line
When deciding to invest in a company, evaluating its return on assets (ROA) is an effective way to measure a company’s overall business performance simply and effectively, even when you’re investing as a beginner.
What is ROA?
What does return on assets mean? Return on assets of a company is defined to be the net income of the company (over the last 12 months) divided by the company’s total assets (averaged over the last 12 months).
The ROA equation is used to determine how effectively a company utilizes its assets in producing profits, which assists investors in analyzing a business’s finances. A high ROA is a sign that the company is managing its finances well, while a low ROA (compared to other companies with a similar business model) suggests that the business is not being run as efficiently as it could be.
- Return on assets (ROA) is a metric that analyzes a company’s performance.
- Investors use ROA to evaluate if a company is using its assets effectively to generate profits.
- Since companies in the same industries have similar asset bases, which is the economic value of a company, ROA is best used to compare companies in the same industry.
Understanding return on asset (ROA) ratios
Running a successful business depends on how efficiently it uses its assets while keeping resources low to grow and profit over time. Since a company’s profit margins are a vital part of success, evaluating return on assets can be beneficial for making sure the company is staying on track and not wasting money and resources.
Many companies depend on industry-specific resources to run efficiently. Some businesses have higher costs to function, so attempting to compare 2 businesses in different industries isn’t a valuable comparison of ROA. To get the best metric of a company’s assets, it’s essential to measure companies in the same industry.
What is a good return on assets ratio?
According to Forbes advisor, a ROA of 5% or more is considered a respectable number, but the higher that number, the better. For example, a 20% ROA is considered excellent and shows a company is very efficient at generating high profits.
What can affect ROA?
ROA is a relatively simple formula, but a few factors can affect financial ratios.
- Company assets are anything that a company owns that adds value to the company, such as cash, equipment, and inventory of goods. To go deeper, we must also look at both current and non-current assets.
Current assets can be converted into cash within a period of a year, whereas
non-current assets may not be convertible into assets within a year, if at all. Both types are taken into account when calculating ROA.
- Expenses and earnings – expenses are how much the company spends, while earnings are how much money the company retains.
Revenue- expenses – taxes= the company’s net income.
The company’s ROA can be affected by either an increase or decrease in spending or earnings.
Return on assets formula
The return on assets formula is a simple one: ROA = net income divided by total assets.
Net income refers to a company’s total profits after deducting the expenses for running the business. It can be found listed at the bottom of an income statement.
Example ROA calculations
Let’s use a simple example to discover how to calculate return on assets.
Mary and Jack both purchase ice cream trucks. Mary buys a used truck for $1,500 while Jack goes out and spends $15,000 on his.
The first week in business, Mary earns $150 while Jack brings in $1,200.
Using the ROA equation: ROA = net income / total assets
- Mary’s ROA is $150 ➗ $1,500 = 10%
- Jack’s ROA is $1,200 ➗ $15,000 = 8%
According to the return on assets formula, Mary runs a more efficient business.
ROA vs. ROE
As you know, ROA is an abbreviation of return on assets, while ROE stands for return on equity. Both can be used to evaluate a company’s financial performance but in different ways.
To calculate the return on equity (ROE), we divide the company’s net profits for a specified period of time by shareholders’ equity, which determines the effectiveness of how a company leverages its assets by selling shares of its stock.
ROA looks at how successful a company is at profiting from its assets, while ROE measures how well a company manages the money invested by shareholders to produce profits. While both ROA and ROE measure how a company utilizes its assets, they treat debt differently.
When a company takes on more leverage and debt, the higher the ROE number is in relation to the ROA, meaning that as a company acquires more debt, the ROE would be higher than its ROA.
ROA considerations for investors
As an investor, there are a variety of ways to research a company, but when your primary focus is on its financial stability, return on assets (ROA) is a simple way to see how effectively its assets are used to generate profits.
When you identify a company with an increasing ROA, it’s a good sign that the company is doing a good job at profiting from the money they spend. A declining ROA can mean a company has overextended itself or may not be managed effectively.
One of the disadvantages of ROA is that you can only use it when comparing companies in the same industry or sector due to their varying asset bases. In addition, the asset base isn’t a projection of a company’s future, as it can change depending on market conditions and the buying and selling of assets.
ROA isn’t perfect. Some of the limitations in using it are:
- It may not be useful for service-based companies due to the limited assets available resulting in high ROAs.
- Capital-intensive industries must spend on regulation requirements and equipment that can shrink their ROA.
Since the formula may need to consider different business and investor situations, there are 2 variations of the formula that rectifies the inconsistent use of the denominator.
ROA formula deviation 1 : net income + [interest expense x (1 – tax rate)] ➗ total average assets.
ROA formula deviation 2: operating income x (1 – tax rate) ➗ total average assets.
The bottom line
What is return on assets? ROA can be used to evaluate companies in the same industry and assist in getting a picture of how efficient they are at making money. A higher ROA can mean a company is doing well at managing earning profits from their assets and can offer a glimpse into possible investment opportunities.
Although there are never guarantees when it comes to investing, ROA can be a beneficial tool for evaluating company performance.
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