There are several measurements businesses and investors used to determine how well a company is performing, and one of the most stringent measurements is return on assets.
Knowing how to calculate a company’s return on assets can help investors determine whether to invest in a company and can help business owners measure how well their company is performing from one year to another in comparison to other companies in their industry.
In this article, we discuss everything you need to know about return on assets including how to calculate return on assets with examples.
What is return on assets?
Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
ROA gives a manager, investor, or analyst an idea as to how efficient a company’s management is at using its assets to generate earnings. ROA is displayed as a percentage.
How do you calculate return on assets?
You can find ROA by dividing your business’s net income by your total assets.
Net income is your business’s total profits after deducting business expenses.
You can find net income at the bottom of your income statement. Total assets are your company’s liabilities plus your equity
What is a good return on assets?
Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower ROA. ROAs over 5% are generally considered good.
What is a bad ROA?
A low or even negative ROA suggests that the company can’t use its assets effectively to generate income, thus it’s not a favorable investment opportunity at the moment.
Although ROA is often used for company analysis, it can also come handy for analyzing personal finance.
How do you increase ROA?
By the following ways ROA can be improved
Increase Net income to improve ROA
There are many ways that an entity could increase its net income. For example, the entity could increase total sales for the period, then net income will increase accordingly.
Improve the efficiency of Current Assets
Current assets consist of cash, receivable as well as inventories. The efficiency of using these assets could keep them low or let them generate additional income.
Receivables are also one of the most important current assets that an entity could manage to improve its ROA when they are low and short outstanding. Good credit policy and collection procedures could significantly help to improve this.
Improve the efficiency of Fixed Assets
Expenses on fixed assets are not charged to income statements at the time they are purchased, but at times they are used based on the system basic.
Improve efficiency ratio on using fixed assets could help the company increase its productivity or in other words, reduce operating costs related to fixed assets.
Why does Return on Assets decrease?
An ROA that rises over time indicates the company is doing a good job of increasing its profits with each investment dollar it spends.
A falling ROA indicates the company might have over-invested in assets that have failed to produce revenue growth, a sign the company may be in trouble.
A low ROA indicates that the company is not able to make maximum use of its assets for getting more profits.
A higher ratio is always better. This is because it indicates that the company is using its assets effectively in order to get more net income.
You must make use of ROA to compare companies in the same industry.
Return on assets vs. return on equity
You have likely heard about return on equity (ROE) before. Both ROA and ROE measure how well your business utilizes certain resources.
ROE only measures your business’s return on equity, not including liabilities. And, ROA accounts for debt, while ROE does not.
While their purposes are similar, ROE and ROA calculate different information about your business.
To measure your business’s financial performance, calculate both ROA and ROE.
Return on assets examples
The following examples show how to calculate return on assets using company’s net income and average total assets.
- Net income: $150,000.00
- Average total assets: $800,000.00
- Total revenue: $1,500,000.00
To find the company’s return on assets using its net income and average total assets, simply divide the company’s net income ($150,000) by its average total assets ($800,000). 150,000 / 800,000 = 0.1875.
Then convert the resulting quotient to represent the company’s return on assets as a percentage (0.1875 = 1.875%). The company’s RAO is 1.875%.
Limitations of Return on Assets (ROA)
The biggest issue with return on assets (ROA) is that it can’t be used across industries. That’s because companies in one industry such as the technology industry and another industry like oil drillers will have different asset bases.
Some analysts also feel that the basic ROA formula is limited in its applications, being most suitable for banks.