The Return on Assets

(ROA)The Return on Assets is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Return on Assets, also called return on investment, measures how effectively a company has generated profits with its available assets. The higher the Return on Assets, the better. But only when the percentage is compared with industry averages can meaningful conclusions be drawn—and only then when a definition of assets is uniform. And assets frequently need to be re-valued, so the definition is critical. Generally the measure reflects management’s ability to generate profits during a given period, usually a year.

There are two acceptable ways to calculate return on assets.

      ROA=Net income/Total assets
      or
      ROA=Net Profit Margin x Asset Turnover

Note: Some investors add interest expense back into net income when performing this calculation because they'd like to use operating returns before cost of borrowing.

The assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund the operations of the company. The ROA figure gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment. For example, if one company has a net income of $1 million and total assets of $5 million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it has an ROA of 10%. Based on this example, the first company is better at converting its investment into profit. When you really think about it, management's most important job is to make wise choices in allocating its resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.

ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or the ROA of a similar company. Capital-intensive industries will yield a low return on assets, since they have to own such expensive assets to do business. Shoestring operations will have a high ROA: their required assets are minimal.Companies such as telecommunication providers, car manufacturers, and railroads are very asset-intensive, meaning they require big, expensive machinery or equipment to generate a profit. Advertising agencies and software companies, on the other hand, are generally very asset-light.

This is an important ratio for companies deciding whether or not to initiate a new project. The basis of this ratio is that if a company is going to start a project they expect to earn a return on it, ROA is the return they would receive. Simply put, if ROA is above the rate that the company borrows at then the project should be accepted, if not then it is rejected. Cory's Tequila Co.'s ROA is 14% - very high, this is over double the cost of borrowing (at time of writing).

Where asset turnover tells an investor the total sales for each $1 of assets, ROA tells an investor how much profit a company generated for each $1 in assets. It's a useful number for comparing competing companies in the same industry. The number will vary widely across different industries. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower return on assets. Companies such as telecommunication providers, car manufacturers, and railroads are very asset-intensive, meaning they require big, expensive machinery or equipment to generate a profit. Advertising agencies and software companies, on the other hand, are generally very asset-light. In the case of a software companies, once a program has been developed, employees simply copy it to a five-cent disk, throw an instruction manual in the box, and mail it out to stores.

Return on assets measures a company’s earnings in relation to all of the resources it had at its disposal [the shareholders’ capital plus short and long-term borrowed funds]. Thus, it is the most stringent and excessive test of return to shareholders. If a company has no debt, it the return on assets and return on equity figures will be the same.

Return on assets is a key profitability measure which can be used to measure relative efficiency of companies within the same industry who have a similar product or service line. ROA is not useful when comparing sectors against each other, companies within different sectors, or even sometimes companies within the same sector. Even though a company may be in the same sector, it does not mean that it will have a similar product or service offering. Typically, this number is most useful when using it as a historical benchmark that a company uses to measure it's relative performance against past periods.