Understanding Return On Assets (ROA)
Return on assets (ROA) is a measure of how efficiently a company uses the assets it owns to generate profits. Managers, analysts and investors use ROA to evaluate a company's financial health.
What Is ROA?
Return on assets compares the value of a business's assets with the profits it creates over a set period of time.
If that sounds abstract, here's how ROA might work at a hypothetical widget manufacturer. The company owns several manufacturing plants, plus the tools and machinery used to make widgets. It also maintains a stock of raw materials used in widget production, plus inventory comprising unsold widgets. Then there's the unique widget designs it's created, and cash and cash equivalents it keeps on hand for business expenses. Collectively, these are the widget manufacturer's assets. The money it earns from selling widgets, minus the cost of materials and labor, is its profits. Both are used to calculate its ROA.
Return on assets is important to keep in mind because it's how a company's managers and outside analysts determine how effectively a company is using its financial resources. ROA is closely related to other measures used to gauge company success, like return on investment (ROI) and return on equity (ROE).
How to Calculate Return on Assets
The basic ROA calculation is very simple: divide a company's net profit by its total assets. You'll then multiply the result by 100 to represent it as a percentage.
ROA = (Net Profit / Total Assets) x 100
You can find a public company's net profit reported on its income statement while total assets are reported on its monthly, quarterly, or annual balance sheet. You should be able to find these statements and sheets in a public company's quarterly or annual earnings reports.
Let's say company ABC reported a total net profit of $2,500,000, with total assets at the end of year listed as $3,850,000.
To determine ROA, you would divide $2,500,000 by $3,750,000, which gives you 0.64935. Multiply by 100 and round up to get the percentage of 6.49%. This tells you that for every dollar in assets held by company ABC, they see 6.49� in profit.
Advanced ROA Formula
A more sophisticated ROA calculation recognizes that the value of a company's assets fluctuates over time. To recognize this, you will need to use the average amount of assets it held over a given year, rather than its total assets at year end. You might find these by averaging the total assets listed in quarterly reports over the course of a year. Once you've determined the average amount of assets for the year, you simply divide net profit by that value and multiply it by 100 to get the percentage.
ROA = (Net Profit / Average Assets) x 100
To continue the example from earlier, let's say you average Company ABC's assets over the course of the year and discover its average asset value is only $3,350,000, lower than the total at the end of the year. When you divide ABC's net profit of $2,500,000 by $3,350,000, you get a ROA of 7.46%. This ROA is higher and more accurate than the original calculation used in the example above.
How to Use ROA
ROA is a helpful metric for gauging a single company's performance. When a firm's ROA rises over time, it indicates that the company is squeezing more profits out of each dollar it spends on assets. Conversely, a declining ROA suggests a company invested poorly, is spending too much or that it's headed for trouble.
You should be very cautious about comparing ROAs across different companies, however. For instance, ROA is not a useful tool for comparing companies that aren't of the same size or that aren't in very similar industries. Expected ROAs might vary even among companies of the same size in the same industry but that are at different stages in their corporate lifecycles.
That's why it's best to use ROA as a way to analyze a single business over time. Plotting out the ROA of a company quarter over quarter, or year over year, will help you understand how well it's performing. Developments up or down may be precursors of longer-term changes.
What Is a Good ROA?
An ROA of 5% or better is typically considered a good ratio while 20% or better is considered great. In general, the higher the ROA, the more efficient the company is at generating profits. However, any one company's ROA must be considered in the context of its competitors in the same industry and sector.
For example, an asset-heavy company, such as a manufacturer, may have an ROA of 6% while an asset-light company, such as a dating app, could have an ROA of 15%. If you only compared to two based on ROA, you'd probably decide the app was a better investment.
However, if you compared the manufacturing company to its closest competitors, and they all had ROAs below 4%, you might find that it's doing far better than its peers. Conversely, if you looked at the dating app in comparison to similar tech firms, you could discover that most of them have ROAs closer to 20%, meaning it's actually underperforming more similar companies.
ROA vs. ROE
Return on assets and return on equity are closely related financial ratios, and they complement each other when evaluating the performance of a single company.
ROE is calculated by dividing a company's net profits over a given period by the shareholders' equity. It measures how effectively the company is leveraging the capital it has generated by selling shares of stock. While ROA examines how well a company is managing its assets in terms of profits generated, ROE examines how well it is managing the money invested by shareholders in terms of profits generated.
Investors understandably want to know how well their equity is being used to generate profit, which is why ROE is a common metric used to measure company efficiency. ROA's measure of asset efficiency, then, complements the conclusions you can draw from ROE.
Limitations of ROA
Though ROA is a helpful calculation, it cannot be the only way investors and analysts measure a company's efficiency and financial health. That's because a company's ROA is influenced by a wide range of additional factors, from market conditions and demand to the fluctuating cost of assets a company needs to acquire. ROA, then, is a metric best taken in concert with other measures, like ROE and ROI, to gain a better picture of a company's overall status.