Return on Assets: What It Means and How It's Calculated
Return on assets is a metric many analysts and investors use to determine how profitable a company is. They also refer to the ROA to compare the performance of different businesses. And while this metric is in wide use nowadays, it still has certain limitations.
So, keep reading to learn how to use the return on assets formula to evaluate a company's profitability and check how it stacks up against the competition.
What Is Return on Assets?
In a nutshell, return on assets is the profitability ratio companies use as an indicator of their performance. It measures a specific business's efficiency, determining whether it has decreased or increased during a certain period. That way, managers, investors, and analysts engage in assessing whether a certain company has been generating a healthy profit in relation to the value of its investments.
For starters, let's elaborate on how to calculate ROA, and take an in-depth look at its limitations and other key points.
The ROA can be calculated by comparing a company's net income (also known as net profit) and average or total assets. The higher the percentage, the more productive the business is. There are various calculations you can use to obtain the return on assets, and the following ones are the most common:
Return on Assets = (Net Income/Company's Total Assets) x 100
Let’s now look at an example. Company X's net income is $1,500, while Company Z’s net income is $2,000. Company X has invested $15,000 in assets, while Company Z's assets are worth $25,000. The calculations are as follows:
|ROA Calculation||($1,500/15,000) x 100||($2,000/25,000) x 100|
In line with this calculation, we can conclude that Company X has a higher return on assets, even though it earned less than Company Z.
ROA = (Net Income/Company’s Average Assets) x 100
Let's take a different approach by analyzing another example. If Company Y has a net income of $5,000 and average assets of $95,000, the calculation is as follows:
|Calculation||($5,000/95,000) x 100|
Many consider this formula more sophisticated than the basic ROA formula because it takes into account changes in the company's average assets. This means you'll need to calculate the value of your company's average annual assets instead of their total value. The average assets used in this calculation could encompass inventory changes, land, equipment, or vehicle acquisitions, and sales oscillations.
Gross vs. Net Income: A Quick Overview
In order to calculate the return on assets correctly, first you need to differentiate between gross income and net income. While the former is based on the entire revenue before taxes and other deductions, the latter is the amount the company gets after paying taxes, employees' salaries, and other non-operational and operational expenses. Proceeds from equipment sales are also added to net income.
Businesses use various types of financing to keep their operations going. The company owners' equity is among them, as specified in the statement that is part of the company’s balance sheet.
Since the company's assets stem from shareholder equity, analysts may disregard the asset acquisition price and add interest expense to the ROA formula. That way, the borrowing cost added to the net income when average assets are used as the denominator negates the effect of taking extra debt.
Furthermore, it’s advisable to compare businesses in the same industry for relevant results. Also, this metric should not be used for comparing companies that are different in size. Another aspect to pay attention to is whether the firms are in the same stage of the corporate life cycle.
Good Return on Assets Numbers
In general terms, an ROI of 5% is considered good, while 20% is perceived as a truly excellent result. Nevertheless, acceptable ROA numbers depend on the industry, sector, period that the calculation pertains to, and other factors. And although a company's ROA may seem above average at first glance, it may lag behind its direct competitors.
To illustrate, we can place companies A and B side by side, even though they operate in different industries. Now, let's say that Company A has a 5.5% ROA, while Company B has 20%, indicating that the latter was a better investment. But, if the return on assets of Company A's closest competitor is 4.4%, while Company B's competitors are ahead (25% ROA and above), it's clear that B is underperforming.
Return on Assets Application
While many investors use this metric to compare two or more companies of similar size and in the same industry, it's best for analyzing a single company. Calculating the company's ROA from one quarter to another or some other period will demonstrate how well the business is doing. If the ROA number is increasing, it means the company has been recording profits. But, if it has been declining, it’s clear that the business's financial performance has been sub-par.
Still, note that the return on assets isn't the only tool you can use to analyze the profitability of an enterprise. In order to evaluate its financial health, it’s advisable to combine several methods. Besides ROA, you can also use the return on equity (ROE), return on invested capital (ROIC), return on capital employed (ROCE), and profit margin.
Limitations of ROA
As mentioned, ROA is unsuitable for comparing businesses that operate in different industries because they don’t have the same asset bases. And although it does indicate how well the company is performing, the ROA is most accurate if combined with other metrics, notably return on equity.
Furthermore, according to some analysts, the basic formula is something banks benefit from the most. These analysts are of the opinion that the bank’s balance sheet reflects the values of their assets and liabilities exactly since they're presented at market value through mark-to-market accounting against historical expenses.
In their opinion, this is how ROA is calculated:
Variation One: Operating Income x (1 - Tax Rate) / Total Assets
Variation Two: Net Income + [Interest Expense x (1 - Tax Rate)] / Total Assets
To calculate operating income, which represents revenue gained from running a business, you should subtract operating expenses from gross income or total revenue.
Return on Assets vs. Return on Equity
Return on equity is a ratio similar to return on assets. The main difference between the two metrics is that you get ROE by dividing the company's net revenue over a defined period by shareholders' equity. In short, ROE calculates how well the business leverages the capital it obtained by selling stock shares.
Consequently, the ROA vs. ROE comparison comes down to whether a company's debt is accounted for (ROA) or unaccounted for (ROE). If the business takes on more debt and leverage, its ROE will be higher than its ROA.
All in all, return on assets is an indicator of how successfully businesses generate profits from their assets. A declining ROA shows that the company has overinvested in assets that have failed to generate adequate profit. On the other hand, if its ROA has been on the rise, the firm is doing well.
Remember that ROA is an excellent metric for evaluating a business's current financial health, although it's not suitable for comparing companies if they aren't in the same industry and similar in size. Lastly, you shouldn't rely on return on assets calculation to assess a business's success. The best results are attained if several calculations are taken into account, i.e., return on equity, profit margin, and other profitability ratios, in addition to ROA.
What is considered a good ROA?
Generally, an acceptable ROA is 5%, while an excellent ROA is 20% and over. Still, these numbers differ between industries, so they should always be viewed in context.
How is ROA used by investors?
Investors may use the ROA to find profitable stocks because the metric indicates how well a company has been performing. If the return on assets number increases, it means the business has been using its assets effectively.
What does ROA mean?
The term ROA means "return on assets." It's a profitability ratio showing a company's financial health by calculating its profit relative to the value of its total assets.
I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.