Return on assets (ROA) is a ratio used to calculate how profitable a business is in relation to its assets. ROA is a financial ratio that helps an investor understand a company’s financial strength. In this article, we will explore how to calculate it, why it's important, and how investors can use it to make more informed investment decisions.
Return on assets is a ratio that helps investors understand how efficiently a company is generating profits on its asset base. The higher the number the better a company is at leveraging its assets to generate return. A company with a larger asset base will need to earn higher profits than a company with a smaller asset base, to reach the same ROA %.
ROA is calculated by dividing a company’s net income by its total assets. It also takes into account a company’s debt. ROA is usually analyzed in relation to similarly-sized companies in the same industry since they are likely to require similar assets for operation.
Comparing ROA across sectors isn't often a good way to gauge a company's performance as ROA can vary significantly from one industry to another. For example, capital-intensive industries like oil and gas would have a lower return on assets than a company in an industry with less required infrastructure like a Software as a Service provider.
Return on Assets Formula
Calculating return on assets is simple. Simply divide a company’s net income by its total assets, then multiply it by 100 to reach a %.
ROA = (Net Income / Total Assets) * 100
Tip: Look at a company’s income statement to find its net income and its balance sheet to find its total assets. However, since a balance sheet is a momentary snapshot of a company’s assets, some people use the average total assets over a particular period of time like a quarter or a fiscal year.
What’s the Importance of ROA?
ROA is a useful metric for investors. There are a few ways investors can use ROA to help better understand the financial performance of a company.
1. Determining Efficiency & Profitability
If a company has a high ROA, the company is operating more efficiently than a company generating a lower ROA. That will have an impact on both short-term and long-term growth, especially if a company is able to maintain a high ROA over time. A company's ROA is best compared to a similar company in a similar industry.
2. Industry Comparisons
ROA can be used to determine how well a company is performing in comparison to its industry peers. For example, if a company has a higher net income than a competitor, it might appear that the company is performing better. However, if the other company has a significantly higher ROA, that company is utilizing its capital and assets more efficiently than the first company.
Tip: Be careful with comparing small and large companies within the same industry as their asset mixes could be different. For example, a legacy financial services company will likely have more assets than a startup fintech company whose business model is based on providing digital services.
3. Comparisons Over Time
Investors may add value to a company if its ROA is consistent from year to year. This is because there is less risk in the assumption of future performance. If there is a big decrease in ROA, that could indicate that the company could face difficulties in the future or perhaps that it overinvested in an unprofitable asset.
What is a Good ROA?
What constitutes a good ROA will depend on the industry the company is in. For some industries, an ROA of 5% may be considered strong. For another industry, an ROA below 15% might be considered low!
On a standalone basis, an ROA measure doesn't help point investors to better stock investment choices.
For one thing, the strong business performance may already be priced into a stock. ROA is also backward-looking, while in the real investing markets stocks are often bid up based on future potential.
Even though ROA is a ratio, comparing this metric between companies of different sizes might still lead to misleading conclusions. Companies within different industries will also have different return ratios. For example, banks tend to have ROA measures around the 1% level, which would seem frighteningly low in other industries.
Companies who have recently ramped-up the purchase of office space, equipment, or manufacturing facilities may have poorer ROA measures in at least the short-term.
Example of How to Calculate Return on Assets
Acme Company is a manufacturing company with a net income of $150 million and $1 billion in total assets. To calculate Acme’s ROA, divide $150 million by $1 billion. The result is 0.15 or 15%.
Acme’s closest competitor is a manufacturing company called Build It Company that has only $50 million in net income but $250 million in total assets. To calculate Build It’s ROA, divide $50 million by $250 million. The result is 0.20 or 20%.
While Acme is able to realize 15% profit for every dollar it has in assets, Build It is able to realize 20% profit for every dollar it has in asset.
ROA versus ROE
ROA measures net income against total assets, while ROE (Return on Equity) measures net income against only the equity portion of the balance sheet. ROA and ROE numbers can vary substantially, based on how much debt a company has taken on.
For a company with no debt, ROA and ROE should be equal. For a company that has taken substantial financial leverage, and has managed to realize favourable investment returns on that borrowed money, ROE will be higher than ROA.
Return on Assets (ROA) is a measure that reflects how well a company is deriving profits from its asset base. The nature of this ratio makes it possible to compare the efficiency of companies of different sizes and capital structure.
The best way to calculate return on assets is to divide net income by total assets. This can be done easily by inputting this formula in a spreadsheet or using business accounting software.
While return on assets expresses how much income a company is able to generate in relation to its assets, return on equity (ROE) expresses how much income a company is able to generate in relation to its shareholder equity. The main difference is that ROA includes a company's debt whereas ROE does not.
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