Importance of Return on Assets in Investment Decision
Created on 18 Aug 2020
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Updated on 12 Sep 2022
In the last blog, we understood the need to analyse how a company uses its investments and assets in order to generate profits and provide returns to its investors, through the calculation of Return on Investment. However, as mentioned earlier, ROI is a broader measure and focuses on the returns generated on different types of investments.
In order to make a clear and well-informed decision, one must focus on the more detailed and concentrated aspects and understand a company's profitability. The next step towards this will be understanding the company's assets' return.
Assets are not just the spending of money but also an investment made in hopes of promising returns, be it short-term or long-term. A company's management of its limited resources gives an insight into the efficiency of its asset management.
In simpler words, a company is said to be financially healthy and profitable if it is able to manage its assets efficiently by squeezing out the best returns from it. Hence, while evaluating an investment decision, it is important to understand how well a company manages and utilizes its assets.
What is Return on Assets (ROA)?
Return on Assets is a type of accounting ratio used to evaluate a company's efficiency to pull out its worth. In simpler words, the ROA ratio is used to evaluate a company's efficiency in using its assets to generate profit. If a company's assets are not used to their fullest potential, they will not generate the desired amount of profits and give lower returns.
The sole purpose of a company's assets is to generate income and revenue for the company. Hence, the return on assets ratio helps the management and the investor understand how well a company can convert its assets investments into profits.
ROA can also be considered as a return on investment as, for most companies, their assets are their biggest investments. The return in such cases is often measured as profits. Higher the company's ROA, the better the utilization of a company's assets.
The ROA of a company can be compared over a period of years. If the company has been showing increasing ROA through the years, that means its profits have also been increasing.
Calculating the Return on Assets
Return on Assets is the ratio of net income after tax to its average total assets.
ROA = Net Income/ Average Total Assets
Net Income = Net Income for the same period as assets
Average Assets = (Beginning + Ending Assets)/2
1. Average Total Assets:
ROA requires the assessment of the company's average total assets as a company's total assets can change over time, with new purchases of land, machinery, sale/purchase of assets, inventory changes, or seasonal sales fluctuations.
Therefore, it is always better to consider the average total assets for the time period rather than calculate the total assets for one period. The total assets of a company can be found on its balance sheet.
One common question while calculating the company's total assets is the treatment of the assets that are different from the common assets. These include intangible assets, non-operating assets, and depreciating assets.
- Intangible assets are not kept in the books, but they make a company incur costs for their acquisition and maintenance; hence this is considered as a cost and is recorded in the income statement, which will directly affect the net income.
- Non-operating assets like unallocated cash and marketable securities, loans receivable, idle equipment, and vacant land are recorded in the balance sheet and will affect the company's average total assets.
- Depreciation is a direct cost to the company and is considered an expense; hence, depreciating assets will affect both the income statement and the balance sheet, thus affecting the ROA ratio.
2. Net Income:
Net Income, also known as 'net profit,' can be found in a company's Income or profit/loss statement. It is the numerator of the ROA ratio. The Net Income calculation considers all the money that comes in and goes out of the company. It is the amount realized after deducting all the costs of business operation in a given period.
According to a definition, net Income is the amount of total revenue that remains after accounting for all expenses for production, overhead, operations, administration, debt service, taxes, amortization, depreciation, and one-time expenses for unusual events such as lawsuits or large purchases.
Also, while calculating the net Income, the first expense after deducting the taxes from the profit is the dividends of the preferred stockholders. Preferred stock dividends or preference dividends are deducted from the income statement.
The reasoning is that preferred stockholders have a higher claim to dividends than common stockholders. After the preference dividend is deducted, then the dividends for the common shareholders will be deducted, thus giving us the Net Income.
Since the net Income is the numerator in the equation, the higher the net income is as compared to the average total assets, the higher and better the return on assets will be for that company.
Similarly, a company with a higher average total asset, which is most companies that are capital intensive, if lower than the net income, will have a lower ROA. Most of the time, a lower ROA can be an indication of poor asset utilization by the company.
If we get into the details, both the components have different effects on the ROA ratio. To understand the effect of both these elements separately, investors prefer the use of 'DuPont Analysis' to better evaluate the impact of net income and total assets in the ROA ratio analysis. A detailed study of the DuPont Analysis will be discussed later in this blog series.
How to calculate Return on Assets?
To make this clearer, let's take a look at the following example:
Company ABC Ltd has posted a net operating income of Rs 86 in current operations in its Profit & Loss Statement and owns total assets worth Rs 500 as per its balance sheet. The debt in the total assets is worth Rs 200, with an interest rate of 6%.
To know the Return on Assets of ABC Ltd, we will use the following formula:
ROA = Net Income/ Average Total Assets
Net income = Operating profit – Taxes
= 86 – (200*6%)
= 86-12 = 74
ROA of ABC Ltd = (74/ 500) * 100
This means that the return on investment of ABC Ltd is 14.8%. For every rupee of the asset, ABC has invested in, the returns would be 14.8 paise in net profit per year.
Importance of Return on Assets
Return on Assets ratio is an important accounting ratio to analyze a company's profitability. It is often used to understand a company's performance within different time periods and compare it with the current situation or is used to compare one company's performance with another company of the same scale of operations, to make a more informed decision. However, it is important to keep in mind the scale of the two businesses and their operations while comparing the performance of two different companies.
Different types of industries have different ROAs. A capital-intensive company that has heavy operations and employs heavy value of fixed assets for its operations will have a lower ROA as their high asset values will increase the value of the denominator of the ROA formula. Such a company can have a higher ratio if its Income is also high enough.
ROAs can also help determine if a company is asset-intensive or asset-light. The lower the ROA, the more asset-intensive company it is. For example, an automobile or airline company will have a lower ROA.
The higher a company's ROA, the less asset-intensive it is. We can also say that the company is asset-light. For example, a software company or an advertising agency are less asset-intensive companies.
Limitations of ROA calculation
The biggest limitation of calculating the ROA is that it cannot be used to compare companies across different industries. This is because companies belonging to different industries will have different asset bases. They will differ in being more asset-intensive or less capital-intensive; hence, a comparison of ROA will not be ideal.
For non-financial companies, debt and equity capital are strictly separated. For debt providers, the return is interest expense, and Net Income is the return for equity investors. So the common ROA formula often mixes things up by comparing returns to equity investors (net Income) with assets funded by both debt and equity investors (total assets).
The Bottom Line
In conclusion, the return on assets ratio is important to understand the company's efficiency to realize the worth of its assets and how efficiently it uses them in its operations. It is an important determinant of understanding a company's financial health. However, due to certain limitations of its derivation, ROA has to be calculated carefully to avoid misleading results and make a well-informed decision.
After considering the return on assets ratio, the next step should be to understand how well the company is using its shareholders' equity or the amount invested by its shareholders to generate profits and if they can provide healthy returns to them or not. This can be done by measuring the Return on Equity ratio of the company, which will be discussed in the next blog of the series.
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