Return on assets (ROA) tells you how profitable a company is relative to its assets. It achieves this through a formula that puts a company’s net income up against the capital it has invested in assets.
This formula was developed by the DuPont company almost a century ago and is used by curious investors and companies which are looking to improve efficiency.
How does ROA work?
The basic ROA formula is very simple. Divide the company’s net income by the worth of its assets. You then multiply this figure by 100 and express it as a percentage. The higher the percentage, the more efficient the company.
So a company with net income of $5m and assets of $30m would have an ROA of 16.7%. Once you have obtained this figure, you can use it to assess a company’s performance. Generally, an ROA of above 20% is seen as excellent and over 5% is pretty good, but circumstances vary from sector to sector.
Automobile manufacturers and transport companies tend to have a large amount of assets, which makes achieving a high ROA much more difficult.
Similarly, companies from sectors with few assets, like the software industry, will have an easier time delivering a high ROA. Because of this, it is generally best to only compare ROAs of companies in the same sector.
Alternatively, you can also make comparisons with previous quarterly or annual results. This is a helpful tool to track performance over time, showing you whether a company is getting better or worse at maximising the productivity of every dollar.
Types of ROA
ROA can be worked out using a company’s average assets or its assets at the end of a period. So ROA calculations from a companies full year results might use the assets at the end of the year. However, you might want to take the company’s assets from the start of the period and the end and work out the midpoint. You can then divide net income by this figure to work out the ROA.
An alternate method of working out ROA is to multiply profit margin by total asset turnover. To find out the profit margin you divide net income by total revenue and multiply this by 100 to arrive at a percentage value. Then, you need to work out the average value of the company’s assets throughout the period.
To do this, add the assets from the start of the period to the assets at the end before dividing by two. Then divide total revenue by this average asset value to arrive at the asset turnover rate. Then you are ready to multiply asset turnover by profit margin to arrive at the ROA.
For example, let’s say a car manufacturer achieved total revenue of $50m and a net profit of $10m. You can use this to work out a profit margin of 20%. The carmaker had assets valued at $100m at the start of the period and $120m at the end. This produces an average asset value of $11om.
Dividing the total revenue by this figure gives you an asset turnover rate of 45.5%. Now you can multiply 20% and 45.5% to land on an ROA of 9.1%. This slightly more complex method offers further insight into other aspects of a company’s performance through the calculations you make along the way.
Advantages of ROA
ROA is very useful for comparing companies to their industry peers or to sector benchmarks. It can also be used effectively to track the journey of a company and look for trends in its ROA. For example, a car manufacturer might have a very low ROA as it seeks to establish itself.
The company could be investing heavily in manufacturing equipment and premises, while still working to expand its sales. The initially low ROA might rise as the manufacturer’s products become more popular, demonstrating a return on the original investment in assets.
Another advantage of ROA is the simplicity of the metric. An ROA of 14% is essentially telling an investor that, during the defined period, the company can make 14 cents on each dollar it has invested in assets.
Finally, you can use the metric in tandem with ROE, or return on equity, to determine a company’s financial health. Together with debt levels, a strong ROA and ROE are thought to indicate a company is using its shareholders’ money well.
Disadvantages of ROA
The primary disadvantages of ROA are its limitations. First is the limitation on its usefulness when comparing companies from different sectors. Some industries, such as manufacturers, rely more heavily on assets than others. Because of this, a higher ROA score is not a guarantee of superior performance when comparing companies with wildly different products or services.
Additionally, the cost of different assets can fluctuate. A company might be heavily reliant on an asset that suddenly rockets in value. This will dilute the company’s ROA but this does not necessarily mean it has performed poorly.
Finally, there is the issue that some companies use net profit to calculate ROA, while others use operating income. This discrepancy can make direct comparisons between different companies’ ROAs problematic.