Understanding return on assets (ROA)
Return on assets, or ROA, is a financial ratio that shows how much profit a company can generate relative to the value of its assets. Expressed as a percentage, a higher ROA means a company can generate greater profits from its assets. A lower ROA indicates productivity and how the company could improve managing its balance sheet.
Investors, managers, and analysts use ROA to assess how effectively companies use their assets to generate cash flow and profits.
The assets ratio is an important valuation and growth metric. A rising ROA means a company is generating more profit relative to its assets, which is likely to increase profits. On the other hand, a falling ROA may indicate bad investment decisions and potential financial struggles.
How do you calculate return on assets?
We calculate ROA by dividing a company's net income by its average total assets. A company's assets encompass all the resources it owns or controls that produce business value, including fixed and intangible assets.
Total assets will vary due to asset turnover, so taking the average value of the company's assets over the period net income is earned is a more accurate way of measuring ROA.
The formula for ROA is:
ROA = net income ÷ average total assets
The figures for the ROA calculation come from a company's financial statements. Net income appears on the income statement as net earnings or net income. Total assets are shown on the balance sheet. You can calculate average assets by averaging the total assets at the start and the end of the income-earning period.
Let's look at an example. Suppose a company's financial statement shows a net income of $15 million and an average of $60 million worth of total assets. In that case, its ROA ratio will be $15 million ÷ $60 million = 0.25 or 25%. This means for every dollar the company invests, it returns 25 cents in profits.
How do investors use ROA?
ROA measures how profitable a business is relative to its assets. It indicates how efficiently a company generates profit (net income) given its asset base. Investors want companies to use their assets productively and efficiently. They have invested capital to generate returns.
We can compare changes in ROA for a single company over time or across multiple companies. A rising ROA is a promising sign, indicating a company is increasing profits with each dollar invested in its assets. On the other hand, a declining ROA could mean shrinking income or that a business has made questionable capital investment decisions.
It is essential to look at ROA in context rather than isolation. One instance of a low ROA may not be concerning if the company is investing in the future and forecasting increasing profits in the years to come.
A 'typical' ROA will differ across industries. Companies with low ROA generally have relatively more assets generating profits than companies with high ROA, which typically have fewer assets.
What is a 'good' ROA?
What constitutes a good ROA will depend on the business you are looking at and its industry. An ROA of less than 5% could be considered on the low side, and an ROA above 20% high.
But it depends on the industry. ROA tends to be lower for capital-intensive industries such as manufacturing because more assets are required. ROA can be quite high in sectors such as technology, where fewer assets are required.
When conducting a ratio analysis, it is essential to consider the types of assets necessary to operate in a given industry. A company may have what appears to be a low ROA, but if it is above the average for the industry, the company is likely performing well relative to its peers.
Investors know that ROA is a relative metric and one of many that need to be considered when making an investment decision. It provides more insight when compared over time to identify trends or compared across similar businesses in the same industry.
Return on assets vs. return on equity
Both ROA and return on equity (ROE) measure how well a business performs and use net income in their calculation. The difference is that ROE measures net income compared to shareholder equity (rather than assets).
If a company has no debt, its total assets will equal its shareholders' equity, and ROA and ROE will be the same. When a company has debts, it increases its assets thanks to the influx of cash. Assets are now higher than equity. Assuming returns are constant, ROA should fall while ROE remains at its prior level.
ROA is a helpful metric because it provides insight into how effectively a company generates profits from its assets. ROE is also beneficial because it measures the return a company generates from its shareholders' equity. The two metrics are often used with other inputs to develop insights into the relative value of individual ASX stocks.
Net profit margin is another ratio that can demonstrate relative efficiency in the use of assets. While ROA uses net income, the net profit margin is calculated based on net income after taxes. Similar to ROA, net profit margin is a profitability ratio used to assess how efficiently the capital employed in a business is used.
Is ROA an important metric for investors?
Return on assets is helpful for comparing different companies and monitoring changes in the performance of individual companies.
Nonetheless, it is not the only metric investors need to master to discover undervalued shares and assess investment prospects. Metrics such as the price-to-earnings (P/E ratio), price-to-book (P/B ratio), earnings per share (EPS), and market capitalisation all have a role to play in informing investment decisions.
Financial ratios such as ROA can help analyse the fundamentals of a company's operations, providing investors with insights into efficiency, productivity, and performance.
A single financial ratio should not be considered in isolation, as context gives meaning to these figures. They can help analyse the relative merits of different ASX shares but should be interpreted as part of a broader analysis.
Shareholders generally seek companies that can increase profits over time. An increasing ROA indicates that a company can deliver increased profits.
ROA cannot tell you everything you need to know to make an investment decision, but it can indicate how efficiently a business generates profits.
