What is Return on Assets (ROA)?

Published by Thomas Herold in Accounting, Banking, Corporate Finance, Investments

'Return on Assets (ROA)' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Return on Assets is also known by its acronym ROA. It is also sometimes called return on investment. This proves to be an indicator of a company’s profitability compared to its aggregate asset base. With ROA, investors and analysts can learn about the big picture of the efficiency of an organization’s management compared to the deployment of their company assets which produces earnings.

This is figured up relatively easily. To calculate the ROA, simply take the corporation’s annual earnings (or income) and divide these by the firm’s total assets. The final answer is the percentage amount of ROA. Other investors will do a slight variation on the formula by adding back in the corporate interest costs to the net income. This allows them to employ operating returns before the net cost of debt.

Thanks to Return on Assets, analysts and investors can learn the amount of earnings that the invested capital or assets produced. Such a figure ranges dramatically from one publically traded company to the next. Every industry’s ROA varies substantially. For this reason, analysts prefer to compare and contrast the ROA primarily against the company’s own prior figures or alternatively versus another company which is both similar and in the same industry.

Company assets are made up of equity and debt together. The two kinds of financing will jointly fund most corporations’ various operations and projects. Because of this Return on Assets number, investors are able to discern the efficiency with which the firm converts its investable money into actual net income. Higher ROA numbers are always considered to be superior. They mean that the corporations can bring in larger revenues and earnings on a smaller amount of investment.

Consider a real world example for clarification. If Imperial Legends Strategy Games produces a net income of $2 million on aggregate underlying assets of $6 million, then it has a Return on Assets of 33.3 percent. Another company Joy Beverages may enjoy the same earnings but against a full asset base of $12 million. Joy Beverages would have an ROA of only 16.7 percent in this scenario. This means that ILSG does twice the job of converting its all around investments into profits as does Joy Beverages. This matters because it speaks volumes of the quality of management. There are not too many managers who are able to turn over significant profits utilizing small investments.

The Return on Assets provides observers with a snapshot and analysis of a business that is distinctive from the usual return on equity formula. Consider that certain industries need to pay more careful attention to the ROA figure than other ones do. In banking, some firms managed to avoid the various banking crises of the last few decades. The ones that sidestepped the problems better than others had something in common. It was that they were more conservative based on the ROA they deployed. The more successful banks did not allow their return on assets numbers to become too unnaturally high. They did this by contemplating the underlying fine details in the loan book. Too many loans that yielded too high a return indicated that management was taking excessive risks. Yet in the business of software development firms, these enterprises are not leveraged, so this ROA comparison is less important.

An important difference separates asset turnover from Return on Assets. Asset turnover specifies that companies have sales which amount to a certain amount per asset dollar on the corporate balance sheet. Conversely, the ROA explains to investors the amount of post tax profit that a firm creates for every $1 of assets it has. This is to say that the ROA compares all of the company earnings relating to the entire resource base the company claims, including both long-term debt and the capital from shareholders. This makes the relevant ROA a strict test of shareholder returns. When companies possess no debt, then their two figures of ROA and ROE Return On Equity will be identical.

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The term 'Return on Assets (ROA)' is included in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.