Return on Assets (ROA)

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Return on Assets (ROA)

Return on assets (ROA) is a financial ratio that shows the percentage of profit a company earns in relation to its overall resources. It is commonly defined as net income divided by total assets. Net income is derived from the income statement of the company and is the profit after taxes. The assets are read from the balance sheet and include cash and cash-equivalent items such as receivables, inventories, land, capital equipment as depreciated, and the value of intellectual property such as patents. Companies that have been acquired may also have a category called "good will" representing the extra money paid for the company over and above its actual book value at the time of acquisition. Because assets will tend to have swings over time, an average of assets over the period to be measured should be used. Thus the ROA for a quarter should be based on net income for the quarter divided by average assets in that quarter. ROA is a ratio but usually presented as a percentage.

ROA answers the question: "What can you do with the assets that you have available?" The higher the ROA, the better the management. But this measure is best applied in comparing companies with the same level of capitalization. The more capital-intensive a business is, the more difficult it will be to achieve a high ROA. A major equipment manufacturer, for instance, will require very substantial assets simply to do what it does; the same will be true for a power plant or a pipeline. A fashion designer, an ad agency, a software firm, or a publisher may require only minimal capital equipment and will thus produce a high ROA. To compare Microsoft with General Motors on the basis of ROA is to compare apples to oranges. The industry average ROA for software companies in mid-2006 was 13.1 and Microsoft's own stood at 20.1. The industry ROA for autos was 1.1 and GM's was a negative 1.8.

The difference between a highly capitalized business and one running largely on intellectual property or creative assets is that, in the case of failure, the capital-intensive company will still have major assets that can be turned into real money whereas a concept-based enterprise will fail when its art is no longer favored; it will leave a few computers and furniture behind. Therefore ROA is used by investors as one of several ways of measuring a company within an industry, comparing it with others playing by the same rules.

USES FOR ROA

Unlike other profitability ratios, such as return on equity (ROE), ROA measurements include all of a business's assets—those which arise out of liabilities to creditors as well capital paid in by investors. Total assets are used rather than net assets. Thus, for instance, the cash holdings of a company have been borrowed and are thus balanced by a liability. Similarly, the company's receivables are definitely an asset but are balanced by its payables, a liability. For this reason, ROA is usually of less interest to shareholders than some other financial ratios; stockholders are more interested in return on their input. But the inclusion of all assets, whether derived from debt or equity, is of more interest to management which wants to assess the use of all money put to work.

ROA is used internally by companies to track asset-use over time, to monitor the company's performance in light of industry performance, and to look at different operations or divisions by comparing them one to the other. For this to be accomplished effectively, however, accounting systems must be in place to allocate assets accurately to different operations. ROA can signal both effective use of assets as well as under-capitalization. If the ROA begins to grow in relation to the industry's as a whole, and management cannot pinpoint the unique efficiencies that produce the profitability, the favorable signal may be negative: investment in new equipment may be overdue.

Another common internal use for ROA involves evaluating the benefits of investing in a new system versus expanding a current operation. The best choice will ideally increase productivity and income as well as reduce asset costs, resulting in an improved ROA ratio. For example, say that a small manufacturing company with a current sales volume of $50,000, average assets of $30,000, and a net profit of $6,000 (giving it an ROA of $6,000 / $30,000 or 20 percent) must decide whether to improve its current inventory management system or install a new one. Expanding the current system would allow an increase in sales volume to $65,000 and in net profit to $7,800, but would also increase average assets to $39,000. Although sales would increase, the ROA of this option would be the same—20 percent. On the other hand, installing a new system would increase sales to $70,000 and net profit to $12,250. Because the new system would allow the company to manage its inventory more efficiently, the average assets would increase only to $35,000. As a result, the ROA for this option would increase to 35 percent, meaning that the company should choose to install the new system.