Return on Assets (ROA) Ratio

Return on assets (ROA) is profitability ratio which measures how effectively a business has used its assets to generate profit. It is calculated by dividing net income for the period by the average total assets.

ROA measures cents earned by a business per dollars of its total assets. A high return on assets (ROA) is generally better than a low ratio. Similarly, an improving ROA is considered a good sign.

ROA should be interpreted with care. Comparison should be made with the relevant industry average or other competitors in the same industry. It is because capital-intensiveness of industries vary. For example, manufacturing companies have high total assets and companies in services industry are more labor-intensive. It would be wrong to compare ROA of a manufacturing entity with ROA of a pharmaceutical company.

Formula

Return on assets (ROA) is most commonly calculated by dividing net income by average total assets

Return on Assets (ROA) = Annual Net Income
Average Total Assets

Net income is the bottom-line figure on income statement. It equals earnings attributable to common stockholders. Average total assets balance is calculated by dividing the sum of total assets at the beginning and at the end of the period by 2. Total assets at the beginning and at the end of the period can be obtained from relevant balance sheets.

Calculating Operating Return on Assets

Return for assets (ROA) is sometimes calculated by dividing earning before interest and taxes (EBIT) i.e. operating income by average total assets. This variant is called the operating return on assets.

Return on Assets (ROA) = Earnings before Interest and Taxes (EBIT)
Average Total Assets

EBIT is sometimes used in the numerator because total assets are financed by a combination of equity and debt. Hence, some practitioners posit that interest expense should not be subtracted because it is a compensation for the debt-financed assets.

Hence, before comparing two ratios from different sources, make sure they use the same formula.

Analysis

Return on assets can be dissected into identify the exact causes of a high or low ratio.

ROA = Total Asset Turnover × Net Profit Margin

If a company has high ROA due to high total asset turnover, you need to make sure that the high turnover is not just due to significantly fully-depreciated fixed assets. Similarly, when ROA is high due to high net profit margin, you need to see that it is not a one-off spike in profitability.

Relationship between ROE and ROA

A company’s return on equity (ROE) depends on its ROE because ROE equals the product of ROA and the company’s equity multiplier:

ROE = ROA × Equity Multiplier

Examples

Example 1: Total assets of Company X on July 1, 20X0 and June 30, 20Y1 were $2,132,000 and $2,434,000 respectively. During the year ended June 30, 20Y1 it earned net income of $213,000. Calculate its return on assets.

Solution
Average Total Assets = ( $2,132,000 + $2,434,000 ) / 2 = $2,283,000
Return On Assets = $213,000 / $2,283,000 ≈ 0.09 or 9%

Example 2: Total liabilities and total equity of Company Y on Dec 31, 20X0 were $942,000 and $1,610,000 respectively. During the year ended Dec 31, 20X0 the company earned net income of $315,000. What were the total assets of the company on Jan 1, 20X0 given that its ROA for the year was 0.12

Solution
Step 1: Average Total Assets = Net Income / ROA = $315,000 / 0.12 = $2,625,000
Step 2: Ending Total Assets = $942,000 + $1,610,000 = $2,552,000
Step 3: Beginning Total Assets = ( 2 × $2,625,000 ) − $2,552,000 = $2,698,000

by Irfanullah Jan, ACCA and last modified on

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