Every business invests in assets because they are made in hopes of assuring return. If a company manages its assets efficiently, it is said to be a profitable company.
Hence, before taking an investment decision, it is required to evaluate how well a company manages and uses its total assets.
The return on assets ratio is used to track the company's assets utilization over a period. Return on assets is one of the different types of return on investment ratio.
In simple words, the ROA ratio indicates the management's efficiency at deploying its assets.
What is Return on Assets?
The return on assets is a financial ratio that helps evaluate the profitability of a company's total assets.
The return on assets is also called "return on total assets" which measures how efficiently a company uses its overall resources to earn profits during a period.
In other words, ROA measures the level of earning generated by a company's total assets.
However, the return on assets ratio helps both investor and analyst, how well managed entities limit investment in non-productive assets.
Higher the return on assets of a company better utilization of a company's assets to generate revenue.
How to calculate Return on Assets?
The return on assets is a profitability ratio that measures how well a company uses its total resources.
The return on assets formula is calculated by net profit by its average total assets. The return on assets formula as follows:
Return on Assets = (Net Profit / Average Total Assets)
Net Profit:
Net profit is also known as 'net income' that is recorded on the company's income statement.
Net profit used as a numerator of the return on assets ratio equation. It is the amount of total revenue left after deducting all expenses, taxes and costs.
However, the higher the net profit compared to the average total assets, the higher the return on assets for the company.
Also, the higher the average total assets and lower the net profit, the lower the return on assets for the company.
Average Total Assets:
ROA needs for the assessment of the company's average total assets because the total assets of the company can change over the period with new purchases of land, machinery, sale/buy of assets, inventory changes etc. for this reason, investors should calculate the average total assets rather than calculate the total assets for a period.
The average total assets can be found on the company's balance sheet and ROA also used for calculating the asset turnover ratio to gauge the company's ability to utilization of a company's assets.
The average total assets formula is -
Average Total Assets = (Aggregate assets at end of the current year + Aggregate assets at end of the preceding year) / 2
Return on Assets Example
Suppose, it is an ABC company. Here is some information about ABC company,
The balance sheet of ABC company as on 31.03.2019
| Particular | Amount |
|---|---|
| Non-current assets | |
| Fixed assets | 425,000 |
| Long term investments | 390,000 |
| Total non-current assets | 815,000 |
| Current assets | |
| Cash in hand | 20,000 |
| Bills receivable | 50,000 |
| Inventory | 250,000 |
| Prepaid expenses | 100,000 |
| Short term loans | 200,000 |
| Total current assets | 620,000 |
| Total assets | 14,35,000 |
| Equity | |
| Share capital | 600,000 |
| Reserve | 330,000 |
| Total equity | 930,000 |
| Non-current liabilities | |
| Debentures | 200,000 |
| Long-term loans | 150,000 |
| Total non-current liabilities | 350,000 |
| Current liabilities | |
| Bills payable | 50,000 |
| Overdraft | 100,000 |
| Short-term loans | 5,000 |
| Total current liabilities | 155,000 |
| Total equity and liabilities | 14,35,000 |
The income statement for the year ended on 31.03.2019
| Particular | Amount |
|---|---|
| Revenue | 10,00,000 |
| Others Income | 500,000 |
| Total Income | 15,00,000 |
| Expenses | |
| Salaries | 300,000 |
| Finance Cost | 150,000 |
| Utilities | 90,000 |
| Inventory | 210,000 |
| Total Expenses | 750,000 |
| EBT | 750,000 |
| Tax @ 30% | 225,000 |
| Net Profit | 525,000 |
ABC company owns total assets worth Rs. 14,35,000 as per the balance sheet and the company's net profit of Rs. 525,000
Return on Assets = (525,000 / 14,35,000)
Return on Assets = 0.36 or 36%
The return on assets of 36% means the ABC company made 36% of profit for each rupee in assets.
How do you interpret return on assets?
The return on assets ratio indicates the percentage of profit a company generates profit its total resources.
In simple words, the return on assets ratio measures how effectively a company earns a return on its investment in assets. Generally speaking, a higher ratio is more favourable to the investors.
In a sense, a higher return on assets ratio indicates that the managerial ability and profitability of the organization. It also shows the company effectively uses its total assets to generate better revenue.
A lower return on assets ratio indicates that managerial incompetence regarding the utilization of assets towards earnings of profit.
Different industries have different ROA's benchmarks because different industries have used different asset classes.
Such as construction companies that use heavy and costly equipment for their operations will have lower ROA because their assets value increase over the period.
While IT companies use computers and servers for their business operations will have lower ROA because the company uses light assets.
Hence, it is important to understand a company's performance within the current situation and at different times or comparing companies within the same sector.
As a smart investor, it is better to find out a trend of the last few years. It is important to note, total assets are the sum of its equity shareholders and liabilities.
Hence, the company's total assets are either funded by equity or debt, some investors and analysts disregard the cost of acquiring the assets by adding back interest expense in the formula for ROA.
What is the difference between ROA and ROE?
Return on equity and Return on assets both are profitability ratio and also measures of how a company efficiently uses its resources.
Generally, return on equity only deals with the company's equity capital and ROE doesn't contain any kind of debt obligations.
Whereas the return on assets measures how the company utilizes its assets and ROA takes into account debts.
However, both ROA and ROE measure for various information about the company and provide insight into how well a company performs compared to its rivals.
What are the limitations of Return on Assets?
The major limitation of the return on assets is that it can not be used to compare companies across various industries.
That is because companies that belong in one industry such as the telecom industry and bank industry will have different asset bases.
For non-financial companies, debt and equity capital is precisely separated. For debt providers, the return is interest expense, and net income is the return for equity investors.
Hence, the common return on assets formula confounds things up with the aid of evaluating returns to equity investors (net income) assets funded by way of each debt and equity investors (total assets).
Frequently Asked Questions
1. What is the return on assets ratio?
The return on assets ratio is a profitability ratio that measures how much profit a company can earn from using its assets.
In another word, return on assets gauges how effectively a company's management generates revenue from its assets.
The higher the number indicates the company's management efficiency at deploying its assets to generate profits and managing the balance sheet as well.
2. What is the return on total assets formula?
Return on total assets estimates how efficiently a company is generating earnings before interest and taxes are paid related to its total assets.
The ratio indicates how efficiently a company is utilizing its total assets to earn revenue. ROA is often exemplified as a percentage.
The return on total assets is calculated by earnings before interest and taxes by average total assets. The return on total assets formula is following:
Return on Total Assets = (Earnings Before Interest and Taxes / Average total assets)
3. What is a good return on assets?
ROAs over 5 per cent are generally considered good and over 20 per cent are considered outstanding.
But the ROA number could vary from industry to industry and ROA also depends on how a company operates.
A bank company has fewer assets than a manufacturing company and bank assets could be concise.
4. What is the average total asset?
The average total asset is illustrated as the average amount of assets recorded on a company's balance sheet at the end of the current financial year and the previous financial year.
Generally, the average total assets are used for calculating asset turnover ratio and return on assets ratio to evaluate the company's capability within the usage of the assets to generate profit.
