Return on assets or ROA is a profitability ratio measuring the efficiency of a company’s management to generate net income by its total assets. In other words, it shows the dollar amount of net income generated by $1 invested in assets. Since ROA measures the efficiency of assets, using it is an important metric for both management and investors.
The formula of return on assets is expressed as follows:
|ROA =||Net Income||× 100%|
|Average Total Assets|
Generally, ROA is calculated for common shareholders. Thus, if a company has preferred equity outstanding, we should use net income attributable to common shareholders, i.e., net of preferred dividends.
The amount of net income can be found in the income statement, and preferred dividends (if available) can be found in notes to the financial statements.
The average amount of total assets is a sum of total assets at the beginning and at the end of the accounting period divided by 2. Total assets are reported in a company’s balance sheet.
Earnings before taxes can also be used to remove the impact of taxation.
|ROA =||Earnings before Taxes||× 100%|
|Average Total Assets|
Such an approach is useful when it is required to compare companies operating in jurisdictions with different tax policies.
The balance sheet of the XYZ Company is as follows:
Balance sheet, US$ in thousands
The reported income statement for the current year is as follows:
The XYZ Company reported total preferred dividends to be paid in the amount of $300,000.
The average total assets are $52,450,000.
|Average Total Assets =||$52,970,000 + $55,870,000||= $54,420,000|
Since the company has preferred equity outstanding, we should adjust net income to the preferred dividends amount of $300,000. Thus, the return on assets of the XYZ Company is 9.28%.
|ROA =||$5,350,000 - $300,000||× 100% = 9.28%|
Trend analysis provides important information about how the ROA ratio has changed over time. Let’s assume that in the previous year its value was 10.65%. The current ratio’s value of 9.28% compared with a baseline of 10.65% indicates the decline in efficiency of assets used to generate profit. In other words, it designates the pure performance of management in this area.
Return on assets ratio works best to compare companies working in the same industry because asset utilization can significantly differ depending on the industry. For example, the automotive industry is characterized by lots of complicated and expensive equipment being used, while a software company uses fewer assets to generate income and profit.
While the ROA ratio isn’t recommended to compare the performance of companies working in different industries, it should be compared with the industry average. Doing this helps to determine whether or not asset profitability is better than average in the industry. Let’s consider the example above and assume the industry average in the current year is 8.41%.
The value of 9.28% compared with an industry baseline of 8.41% indicates that management is still sufficiently effective in generating profit on money invested in the company’s assets.