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What is Return on Assets (ROA)?
The Return on Assets (ROA) measures the profitability of an organization in relation to its total assets. A company's Return on Assets (ROA) is an important tool for determining whether its assets are being used to generate profits efficiently. Generally, ROA refers to the returns generated by an investment. An organization with a higher return on assets is more efficient. As a result, the company can earn more money with a smaller investment. ROA is calculated by dividing net income by total assets. ROA includes the debt of the company, while Return on Equity (ROE) only considers equity.
As with other ratios, when comparing ROA among companies, it is important to take the industry into account. ROAs of technology companies may differ from those of food and beverage companies. Thus, it is more appropriate to compare the current ROA with the ROA of similar companies or the ROA of past periods of the same company.
Using ROA, investors are able to identify stocks that appear to be attractive for investment. Continuously increasing ROAs indicates that the company is able to increase profits with each unit of invested capital. On the other hand, a decreasing ROA may indicate that a company has invested too much in assets that do not produce earnings growth or are not profitable. As such, this ratio provides insight into the efficiency in which a company utilizes its total assets.
How to Calculate ROA
The return on assets is calculated by dividing the net profit of a company by the total assets. A company's total assets are equal to its total liabilities and equity. The two types of financing are used to fund the operations of a company. As the total assets of a company can fluctuate over time. Examples may be inventory changes or seasonal fluctuations in sales. Therefore, ROA is calculated based on the average total assets of the company.
ROA Calculation Example
Consider a situation in which a real estate company has only one rented property on its balance sheet. The property is valued at CHF 2 million. Company assets consist of 50% equity (CHF 1 million) and 50% debt (CHF 1 million). An annual interest payment of 5% is required for the debt capital. Having to pay interest reduces the company's profits. A rental income of CHF 100,000 is generated each year. Taxes and depreciation are not included in this example. Thus, the profit for the year is CHF 100,000 less the expenses for the loan of CHF 50,000. Nevertheless, the interest expense must be added back to the annual profit in order to calculate the correct amount.
When debt capital is used, the Return on Equity (ROE) changes. This phenomenon is also known as the leverage effect. The ROA, however, remains unchanged. In the case of a company financed solely by equity (i.e. CHF 2 million), the ROA is also 5%.
It should be noted, however, that in this example taxes are not considered. The interest on borrowed capital is an expense that reduces profits but reduces the tax burden as well (tax shield). Thus, the total capital ratio may differ since profit can change when taxes are taken into consideration. Assuming taxes amount to 5% as well, the calculation looks as follows:
ROA's Disadvantages
One weakness mentioned earlier is that companies' ROA cannot be compared across industries. Different companies in different industries have a different composition of total assets. Some analysts believe that ROA is not a good metric for all companies. For banks, for example, ROA is very useful because balance sheets represent the real value of their assets and liabilities. For other companies, however, it makes more sense to consider debt and equity separately. Interest expense is the rate of return for the lender while net income is the rate of return for the equity lender. Therefore, it does not make sense to compare the net profit, i.e. the return for equity providers, with the assets financed by debt and equity providers (total assets). For this reason, the following variant is often used to calculate the ROA:
Thus, the positive tax effect or the so-called "tax shield" is also taken into account, as the interest expense can be claimed for tax purposes.
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