Return on assets (ROA) is an indicator of how well a company is able to make use of its assets. ROA is the ratio of net income to the total average assets of the company.
How can you calculate return on assets?
The formula to calculate return on assets is:
Return on assets is a financial ratio that indicates how well a company’s management makes use of the available assets. It’s useful for any prospective investor to know the efficiency with which management utilizes resources. The management of the company can also use the same ratio to identify if they are underutilizing their assets to generate earnings compared to their peers.
Making sense of return on assets
Broadly speaking, capitalism rewards efficiency and punishes inefficiency. Businesses try to make a profit by bringing efficiency to areas that are inefficient. The goal is to eke out maximum efficiency out of the available resources. The return on assets ratio tries to measure this efficiency.
ROA is calculated with net income, which is the income left after paying all the business’s operations costs. These costs include:
- Cost of goods sold
- Interest expenses
- Taxes
- Depreciation
- Amortization
In simple terms, ROA calculates the amount of earnings generated from the total assets. Total assets can also be considered invested capital. ROA measures the efficiency with which the company employs capital. Even with a lower income, a business can display better efficiency than its larger counterparts.
Consider 2 lemonade stands, A and B. A spent capital only on the essentials to make lemonade, namely lemon, water, sugar, ice cubes, cups, a basic table, and an employee. The total assets were worth $150. A raked in a profit of $50 by running the stand. On the other hand, B spent lavishly on lights to decorate the stand, an expensive name board, and other marketing expenses. In total, the assets employed by B came to $500, earning a profit of $120. Let’s calculate the ROA for both businesses:
Here we can see that even though B brought in a larger profit, A created the profit more efficiently. While B had to spend $500 to earn a profit of $120, A spent only $150 to earn a profit of $50. For investors, investing in A is a better proposition than investing in B. Shareholders can gain a better return on capital by investing in A. The management of B can look at its ROA compared to peers and determine where it spends more capital and streamline the business.
A higher ROA is the hallmark of an efficiently run business, but it differs in different industries. Some industries like software are asset-light and generate a high return on assets compared to other industries. Meanwhile, asset-intensive businesses like airlines typically have a low ROA.
Even within the airline industry, there’s a difference in the ROA between different models of operations. Airlines that operate in a leasing structure require fewer assets, while airlines that own aircraft have more assets. The ROA of companies should be compared with industry peers keeping in mind the business model of individual businesses.
