Return on assets, popularly referred to as ROA, is a financial ratio that indicates profitability of a company in relation to its total assets for a period. Retrun on assets (ROA) shows how efficient the management is in generating profit by using the company’s assets.
In this article you will learn how to calculate return on assets (ROA) and how to interpret the ratio to understand companies efficiency.
How to calculate return on assets (ROA)
You can calculate return on assets by dividing a company’s net income by its total assets.
As a formula, ROA is expressed as:
Return on Assets = Net income / Total assets
Net income or profit can be found at the bottom of the company’s income statement.
Assets can be found on the company’s balance sheet.
Return on Assets (ROA) is a measure to indicate how the company has performed in terms of profitability in relation to its total assets. In other words, it shows you what earnings the company has generated from invested capital or assets.
Please note assets are funded by both debt and equity, therefore, it’s taking total invested capital into account.
Therefore, assets are funded by debt as well. Due to this some financial analysts prefer to add back interest expenses to net income and divide it by total assets to get return on assets.
They use following formula to get ROA;
Return on asset (ROA) = {Net Income + [Interest Expense x (1 – income tax Rate)]} / Total Assets
Now you know how to calculate return on assets. Based on this calculation, it is used as a metric to know a company’s profitability in relation to its total assets.
How to use Return on Assets (ROA)
Financial analysts use ROA as an important financial ratio to determine whether the company uses its assets efficiently in order to generate a profit.
A higher return on asset means the company’s management is very efficient and productive while using various assets of the company to generate profits for shareholders.
In contrast, a lower Return on Assets (ROA) indicates inefficiency of the management or there is room for improvement.
You can not make decisions based on a company’s Return on Assets (ROA) alone. You need to take other fundamental factors into account in addition to the company’s ROA.
It’s always better to compare return on assets ratio with the same industry standards as they share the same asset base to generate profit for shareholders.
Return on equity (ROE) is also used as a popular financial ratio to indicate efficiency of the management. However there is a difference between ROE and Return on Assets (ROA).
The main difference between return on assets (ROA) and return on equity (ROE) is that the ROA takes companies debt into account while ROE does not.
You should always use Return on Assets (ROA) as a comparative measure. It is always better to compare it with the previous ROA numbers and with other similar types of company’s Return on assets.
One of the biggest disadvantages of ROA is that it can not be used across industries. That is because one industry may have different asset bases than those in another. For instance, assets used in retail business are not the same as the asset base of the infrastructure sector.
Similarly, ROA for banks and software companies will be significantly higher than the return on assets of a company from a capital-intensive sector such as construction or utility industry.
Rising ROA indicates that the company is doing well. In contrast, falling ROA indicates that the company failed to produce revenue growth in comparison to the money invested in its assets.
