Fundamentals of return on assets
Efficiency is one of the characteristics of a successful business, as it needs to get the most out of minimal resources or average assets. The calculated return on assets shows that resources are being used in a way that brings in a return.
Usually, businesses compare the profits they earn to the money invested. Although this is important, how well a company uses its assets highlights the reality of how well it’s operating.
Sometimes the terms ‘return on assets’ and ‘asset turnover ratio’ are used interchangeably. But return on assets is calculated using net income, while asset turnover is calculated using revenue.
The ROA calculation
Calculating return on assets is simple when you use the return on assets formula as follows:
Return on Assets = Net Income ÷ Average Total Assets
If the return on assets ratio is fairly high, it usually means that the company is using or controlling its assets efficiently. Investors use this metric when deciding if they should invest in this particular company.
What is an asset?
Here are types of assets as found on the balance sheet:
- Cash or cash equivalents
- Marketable securities
- Accounts receivable
- Prepaid expenses
- Long-term investments
- Fixed assets
- Intangible assets.
Capital-intensive businesses have many assets in the form of property, plants and equipment to produce goods or services.
Return on assets examples
Here are a few examples that will help you understand how return on assets helps in determining the efficiency of a business.
If a company has fixed assets of $500,000 and its net income is $50,000, then the return on assets is $50,000 ÷ $500,000 = 0.1 or 10%.
Another company has total assets of around $250,000 and a net income of $50,000. The ROA is $5000 ÷ $25,000 = 0.2 or 20%.
When you compare businesses using return on assets, it should be for companies in the same industry, as ROA can vary substantially between industries that have different types of assets.
If we use the examples of the two businesses above and assume they are in the same industry, we can see that the second company is achieving a better result than the first.
An investor comparing the two companies will be more likely to invest in the second because it is managing its assets more effectively. It indicates that the business management team knows how to get more out of the assets it holds. Of course, other factors will be considered before making investment decisions.
The return on assets also gives managers a benchmark to determine how well the business is performing. Here’s a list of average return on assets by industry. If the ROA of a business is well below the industry average, it’s a sign that the assets aren’t being managed efficiently and being used to maximise results.
Other essential reports and indicators to check along with return on assets
While return on total assets or return on assets measures how well a business is using its total assets, there are other ways to check how a company is doing, including the following ratios and reports:
Return On Equity: Return On Equity (ROE) is a financial ratio used to measure the profitability of a company by relating it to equity. You calculate this ratio by dividing net income by shareholder equity. The percentage you get from this calculation will determine if the share price is appropriate when compared to other companies in the industry.
Income Statement: This is another crucial financial statement, as it presents a company’s net profit and loss. An income statement shows you the income and expenses of a business. This document shows the company’s financial results for a specific period, usually one year. Interest expense as shown on the income statement indicates how much interest a company has to pay to its lenders for borrowing money or other things such as loans, lines of credit, bonds, etc.
Balance Sheet: A balance sheet is another important financial document that’s used to determine how well a company is performing. This lists things such as company assets, liabilities, and shareholder’s equity. You can also find information on accumulated depreciation of assets in this report. The balance sheet should be used in conjunction with other financial reports when making business decisions.
EBIT: Earning Before Interest and Taxes (EBIT) is another indicator that helps you to determine the financial health of a business. You calculate EBIT by using one of the following formulas:
EBIT = Net Income +Taxes + Interest
EBIT = Revenue – Cost of Goods Sold (COGS) – Operating Expenses
Using these ratios and financial statements along with the return on assets ratio will give you a clear picture of how a business is performing. You can also use them when considering the financial impact of purchasing assets using finance, such as business loans.