The return on assets (ROA) is one of the five financial ratios classified under Profitability Ratio. It measures the return earned on total assets employed in the business. The higher the return, the more productive the company is in utilizing her resources. This return refers to the net income divided by the average total assets, which represents the simple average of the total assets at the beginning and ending balance sheets.
Net income is the net amount after deducting all cost of doing business in a given period of time. The cost of doing business include all interest paid on debt, corporate income tax paid to the government, all operational expenses and non operational expenses.
Formula of Return on Assets
Return on Assets = ( Net Income ) / Average Total Assets
As an example, if a company has $10,000 in total assets and generates $2,500 in, its would be $2,500 / $10,000 = 0.25 or 25%.
Why Return on Assets is important?
Companies in different industries vary in their use of assets. For example, some industries such as airline companies may require expensive plant, property, and equipment to generate income. This is as opposed to other asset light industries like software companies.
Assets intensive companies would naturally report a lower return on assets when compared to assets light companies. Therefore, return on assets should not be compared across industries. Only compare ROA with companies in the same industry.
Which one of the two companies in the same industry would you invest?
- Company A : net income of $10 million and assets of $100 million,
- Company B : net income of $10 million and assets of $15 million.
The answer is quite obvious, right? Yes, you should invest in Company B with higher ROA.
Falling ROA may be a big problem. You should take note that thedoes not account for outstanding liabilities and may indicate a higher level than actually derived. Hence, it leads me to introduce the next financial ratio called Return on Equity under Profitability Ratio.
Check out other Profitability Ratios.