Return on assets (ROA) is a profitability ratio that helps determine how efficiently a company uses its assets. It is the ratio of net income after tax to total assets. In other words, ROA is an efficiency metric explaining how efficiently and effectively a company is using its assets to generate profits.
Calculate Return On Assets (ROA) Using Formula
The formula for ROA is very simple which is expressed below:
Return on Assets = Profit after Taxes / Total Assets
The numerator is the profit considered after deducting the costs, depreciation, and tax etc. One important thing to keep in mind while arriving at this figure is to consider the profits which are generated using such assets. Incomes generated from activities in which there is no contribution of these fixed assets should be excluded for this purpose. The denominator comprises of fixed as well as current assets. A more accurate version of ROA is when average total assets are considered i.e., the average of the opening assets at the start of the accounting period and closing assets at the end of the accounting period.
A different expression of ROA formula can be as follows and that gives better and deeper insight of this ratio.
|Profit after Tax||Total Revenue|
|ROA||=||————–||*||————–||=||Profit Margin * Asset Turnover Ratio|
|Total Revenue||Total Assets|
From this expression, a company can make out what is driving its ROA. Is it because of higher profit margins or due to higher asset turnover? Say, a 20% ROA can be a result of 10% margin * 2 times asset turnover or 5% margin * 4 times asset turnover.
Return On Assets (ROA) Example
Below is a sample of financial figures for ABC Co.
All figures in USD. The accounting period under consideration is Financial Year 2011-12.
|Net Profit after tax||=||20000|
|Return on Assets||=||Profit after Tax / Total Assets|
From the above illustration, ROA is 0.2 or 20%. From this, one can conclude that for every dollar invested in the assets of ABC Co, it results in a profit worth 20 cents. In other words, to create 1 unit of profit, 5 units need to be invested in the assets of the company.
Interpretation of Return on Assets (ROA)
Return on assets is a measure of how effectively a company uses its assets. Higher is this figure, better is the utilization of the company’s assets. For e.g., a company may earn profits worth 1 million with an investment of 10 million giving ROA of 10%. On the other hand, another company can give the same profit with an investment of just 5 million, giving an ROA of 20%. The second company certainly is utilizing its resources better because although both are generating the same profits, the second company is doing it with half the investment. It’s easier to generate profits if you pump in the huge amount of money. But one needs to consider the cost of capital and the opportunity cost as well with every investment being made.
Thus, investors can use the ROA figure to analyze which company has efficient utilization and thus make an informed choice before investing in a company. One can even compare ROA for a company over a period of 5-10 years. An increasing ROA suggests the profitability of the company is increasing. On the other hand, a decreasing ROA can be an indication that the company’s performance is deteriorating.
Reasons For Lower ROA
Lower Asset Productivity
Lower productivity of the assets is the key reason for lower ROAs. This can be cured by proper repair and maintenance or replacement of old assets. The techniques of capital budgeting may help solve such dilemmas.
Too much of wastages could also be inferred as a reason for lower ROA. Reducing wastages is a major challenge in most of the manufacturing companies. Wastages not only means the product or raw material wastage, the wider meaning of wastage includes idle labor hours, etc. Proper production planning and the process of testing the products at every stage can significantly reduce the wastages.
Other reasons could be the higher cost of machinery, higher interest rates etc.
Caution While Using ROA Ratio
Return on assets of different companies can be compared only to companies within the same sector. Comparing ROAs of companies belonging to different sectors can be misleading. This is because some sectors require huge initial investment and have long gestation periods. For such companies, ROA will be relatively low. E.g., companies belonging to infra and airlines sector.