A company’s asset’s ability to produce a return
In short:
Return on assets (ROA) is a financial performance ratio used to describe the percentage return a company is earning on the assets it employs. The ratio is calculated by dividing the company’s annual net income by its total assets.
ROA is most insightful when it is compared to the company’s past ROA. This allows company managers, investors, and analysts to gauge how well a company is using its resources.
Formula:
Key Points
- Return on assets (ROA) is a financial performance metric that measures the profitability of a company relative to its assets.
- ROA is a comparative metric that can be used against the historical ROA of a company or to compare to other companies in the same industry.
- The value of ROA as a financial performance metric depends heavily on the industry the company operates in. Meaning it is not over insightful to all companies.
In-depth:
Understanding ROA and How to Calculate it
While the amount may vary, all companies require some amount of assets to be in business. It is only natural then for company managers and investors to ask the question, “how much are we actually making on the assets we own?”. This is where return on assets (ROA) comes into play.
ROA provides a quick means to measure this particular aspect of a company’s financial performance. The calculation is quick because it only requires the annual net income from the income statement and the total assets from the balance sheet. Once this information is obtained, net income is divided by the total assets resulting in the percentage return on the company’s assets. That is, if a company has a ROA of 15% this means for every $1 of assets the company is earning 15¢.
Ex.
ROA = Net Income / Total Assets
Usefulness
The usefulness of ROA will heavily depend on the industry the company is operating in. ROA may not be a very insightful metric for all industries as some industries do not require very many assets to generate income nor are their earnings tightly related to their assets.
For example, an asset-light business such as a tech company does not require many assets in order to generate income. Given the limited dependency on assets, a company in this space may rely on other factors to influence its income that are not well represented by the “assets” line item on the balance sheet.
Compare the example above to an airline which is a very asset-heavy business. While airlines may have different strategies on how they’ll generate income, none can get around the fact that they will need commercial aircraft in order to do their business. ROA in this case might be a much more useful metric as the dependency on the “assets” line item on the balance sheet to generate income is much tighter.
Think of it like this, not all software is created to do the same job but all commercial airplanes are created to generally do the same job.
*More useful for banks, industrials, etc. than for tech companies.
Weak spots
Unfortunately, like with any simple calculation in finance, it is open to weaknesses. The arguably biggest weakness of ROA is that it can be manipulated. For example, if we are looking at the ROA of a company and the company did an asset write-down, which is where they come in later and basically says “oh these assets aren’t quite worth what we thought or said they were”. This would boost the ROA since we are now dividing the net income by a smaller denominator value.
The other way a company may influence ROA is to repurchase shares, this would use cash from the assets side of the balance sheet and result in a lower asset value as well.
It should be noted that asset write-downs are not always for malicious intent neither are share repurchases. Actually, share repurchases are another form of a dividend to investors so they are typically a good thing. The point is, analysis should go further than just one metric.
Example ROA Calculation
Let’s look at a simple example to better understand how to calculate ROA. Say we were looking at a company that sells specialty ice cream to high-end clients. If it takes them $500,000 of assets such as ice cream machines, clothing, branding, etc to put their ice cream together and they are able to turn a net income of $93,000 what is their ROA?
To solve we simply divide $93,000 by $500,000 which results in 18.6%.
Note that we did not account for how the ice cream company funded its assets only that it had assets worth $500,000. The amount of borrowing a company does to acquire its assets will impact its owner’s returns more than just the asset value.
Return on Assets (ROA) vs. Return on Equity (ROE)
While ROA can be a useful metric to measure the profitability of a company against its assets, common stock investors may also want to know how efficiently a company is using the capital they are providing. To view how a company is performing on just its invested equity company managers and investors may look at return on equity.
Return on equity (ROE) is the return a company is generating per dollar invested by its equity investors, expressed as a percentage (ex. 15%). Simply put, ROE is a financial performance measurement that describes a company’s ability to produce a profit with respect to shareholder’s equity.
The difference between ROA and ROE is that ROA doesn’t differentiate between assets funded by debt vs assets funded by equity investors, it includes all assets the same. ROE includes only assets that belong to equity investors.
Return on Assets (ROA) vs. Return on Invested Capital (ROIC)
So, what if you wanted to know how well a company is performing on all its invested capital? That is, what the company is returning on both capital from its debt investors and from its equity investors. In this case, a company manager or investor would turn to a slightly more complicated ratio, the return on invested capital.
Return on invested capital (ROIC) is a profitability metric used by investors to measure how well a company or project is able to generate a percentage return on the capital it uses. Simply put, ROIC serves as an indication of the returns a company is producing on each dollar invested. The important thing to note is that invested capital includes all investors, meaning both debt and equity investors.
The big difference between ROA and ROIC is that ROIC includes the after-tax interest expense in the numerator, i.e. the debt investors haven’t been paid yet. With ROA the numerator is net income, meaning the debt investors have already been paid. So with ROA you are comparing an equity-only figure to a debt + equity figure which you should be aware of.
*ROIC is more complicated to calculate and includes important details we have left out here for simplicity. If you want to know more about ROIC please see our article on ROIC.