What is Return on Assets (ROA)?
Return on assets (ROA) is the ratio between net income, which represents the amount of financial and operational income a company has got during a financial year, and total average assets, which is the arithmetic average of total assets a company holds, to analyze how much returns a company is producing on the total investment made in the company.
Return on Assets of General Motors (5.21%) is greater than that of Ford (3.40%) for FY2016. What does it mean? It relates to the firm’s earnings to all capital invested in the business. In this article, we will discuss Return on Assets in detail.
Trying to understand how much revenue one firm would earn by employing its assets is not a good measure. So there should be something that is more refined. And the refinement has been done in Return on Assets ratio.
When we calculate the asset turnover ratio, we take into account the net sales or the net revenue. However, revenue always is not a good predictor of success. There are many organizations that earn good revenue, but when we compare the revenue with the expenses they need to bear, there would hardly be any profit. So comparing net revenue with the total assets wouldn’t solve the issue of the investors that want to invest in the company.
Take an example of Box Inc. Let us have a look at its Asset Turnover Ratio. This asset turnover doesn’t tell us much about the performance of Box Inc.
source: ycharts
However, when we look at the Return on Assets Ratio of Box Inc, we note that it has been negative all the way. This implies that the company is unable to generate returns with respect to its deployed capital.
source: ycharts
Return on Assets Formula
Let’s have a look at its formula
Return on Assets Formula = EBIT / Average Total Assets
There are diverse opinions on what to take in the numerator of this ratio! Some prefer to take net income as the numerator and others like to put EBIT where they don’t want to take into account the interests and taxes.
- My personal advice is that you should consider EBIT as this term is before interest and taxes (pre-debt and pre-equity).
- Likewise, when we are comparing it with the Denominator i.e. Total Assets, we are taking care of both the Equity as well as Debtholders.
- Net Income / Average Total Assets may be an incorrect comparison, primarily due to its numerator. Net income is the return attributed to the equity holders and denominator – Total Assets considers both Equity and Debt. This means we are comparing apples to oranges 🙂
Let’s talk about the average total assets. What will you take into account while computing a figure of average total assets? We will include everything that is capable to yield value for the owner for more than one year. That means we will include all fixed assets. At the same time, we will also include assets that can easily be converted into cash. That means we would be able to take current assets under total assets. And we will also include intangible assets that have value but they are non-physical in nature, like goodwill. We will not take fictitious assets (e.g. promotional expenses of a business, discount allowed on the issue of shares, a loss incurred on issue of debentures, etc.) into account. Then we would take the figure at the beginning of the year and at the end of the year and would find an average of the total figure.
Interpretation of Return on Assets
- The reason we took EBIT for calculating Return on Assets Ratio is that this would give a holistic picture of the company. And thus the interpretation of the ratio would be much more holistic.
- Let’s say that the investors find out that the ROA of a company is more than 20% for the last 5 years. Do you think it’s a good measure to invest in the company for future benefits? The answer is of course, yes! It’s far better to invest in a stable company than a company which produces volatile profits over the years.
- In simple terms, we can say that increase in the ROA means better use of assets to generate returns for the firm and its decrease means that the firm has a room for improvement – may be the firm needs to reduce few expenses or to replace few old assets that are eating out the profits of the company.
Return on Assets Calculation Example
Particulars | Company A (in US $) | Company B (in US $) |
Operating Profit – EBIT | 10000 | 8000 |
Taxes | 2000 | 1500 |
Assets at the beginning of the year | 13000 | 14000 |
Assets at the end of the year | 15000 | 16000 |
Let’s do the calculation to find out the Return on Assets for both the companies.
First, as we have been given Operating Profit and Taxes; we need to calculate the Net Income for both of the companies.
And as we have the assets at the beginning of the year and at the end of the year, we need to find out the average assets for both of the companies.
Company A (in US $) | Company B (in US $) | |
Assets at the beginning of the year (A) | 13000 | 14000 |
Assets at the end of the year (B) | 15000 | 16000 |
Total Assets (A + B) | 28000 | 30000 |
Average Assets [(A + B)/2] | 14000 | 15000 |
Now, let’s calculate the ROA for both companies.
Company A (in US $) | Company B (in US $) | |
Operating Profit EBIT (X) | 10000 | 8000 |
Average Assets (Y) | 14000 | 15000 |
ROA (X/Y) | 0.75 | 0.53 |
For Company A, the ROA is 75%. 75% is a great indicator of success. And if Company A has been generating profits in the range of 40-50%, then investors may easily put their money into the company. However, before investing anything, the investors should cross-check the figures with their annual report and see whether there is an exception or any special point is mentioned or not.
For Company B also the ROA is quite good, i.e. 53%. Usually, when a firm achieves 20% or above, it is considered healthy. And more than 40% means the firm is doing quite good.
Return on Assets Calculation for Colgate
Now let’s understand the ratio from a practical standpoint. Below is the snapshot of Colgate’s Balance Sheet.
Below is the snapshot of Colgate’s Income Statement. Please note that we need to use EBIT for the Return on Total Assets calculation.
Colgate’s Return on total assets has been declining since 2010. Most recently, it declined to its lowest to 21.9%. Why?
Let’s investigate…
Primarily there can be two reasons that contribute to the decrease – either the denominator i.e. average assets have increased significantly or the Numerator Net Sales have dropped significantly.
In Colgate, we note that the total assets have decreased in 2015. The decrease in total assets should ideally lead to an increase in the ROTA ratio. This leaves us to look at the Net Sales figure.
The primary reason for the decrease in sales was the negative impact due to foreign exchange of 11.5%.
Organic sales of Colgate however, increased by 5% in 2015.
Return on Assets – Banks
In this section first, we will look at a few banks and their Return on Total Retail Assets so that we can conclude how good they are doing in terms of generating profit.
source: ycharts
From the above graph, we can now compare the ROA of the top global banks.
The highest ROA has been generated by Wells Fargo of 1.32% and the lowest return on assets ratio has been generated by Mitsubishi UFJ Financials of 0.27%. All other banks’ returns on total assets are between 0.3%-1.3%.
To understand where these banks stand in terms of comparison, we can take an average and compare each bank’s performance. We have taken each bank’s ROA and the average ROA is 0.90%. That means many banks that are performing over 0.9% are doing good.
Limitations
- If we take into account Net Income to calculate the ratio, then the picture wouldn’t be holistic as it includes Taxes and Interests (if any). But in the case of EBIT in number, we don’t need to worry about that.
- For industries that are an asset, intensive won’t generate that much income compared to the industries which are not asset-intensive. For example, if we take into account an auto industry, to produce auto and as a result of that, profits; the industry first needs to invest a lot in the assets. Thus, in the case of the auto industry, the ROA won’t be that higher.
- However, in the case of services companies where investments in Assets are minimal, then the ROA will be pretty high.
In the final analysis
As an investor, you should definitely find out Return on Assets ratio before investing in a company. But along with that, you should also consider other metrics like Return on Equity, Return on Invested Capital, Current Ratio, Quick Ratio, Du Pont Analysis and so on and so forth.