We all have made investments in assets once in our lifetime, may it be gold or electronics. And once we made those investments, we would have also expected some return from them.
This return would be an increase in value, efficiency, or end-of-the-day happiness received through using the asset. But this is in our day-to-day lives.
So, what about the companies and industries that invest in assets?
The industry term for the return received through the investment in assets is known as Return on Assets. In this blog, we’ll dive into Return on Assets and in detail understand different topics like the formula to calculate ROA, differences between ROA and ROE (Return on Equity), and much more.
ROA is a financial ratio that reveals how profitable a company is, based on total assets. We can also know how efficiently a company utilizes its assets to generate profit through its ROA.
ROA – Key Points
- ROA is a financial metric to analyze a company’s ability to use assets and generate profit.
- Higher the ROA measure, the better the performance of a company.
- Net income divided by the total assets of a company gives its ROA.
- It is best to compare the ROA of a company in one industry to the ROA of another in the same industry as the metrics used to value the assets will remain the same.
- It is said that ROA factors in the debt of a company, but ROE doesn’t.
ROA as a comparative measure
Efficiency is a core metric for analyzing the performance of any business. Comparing profits to revenue may give out the performances of companies, but comparing profits to assets used by the companies gives out the practicality of that company’s existence.
For any public company, ROA can differ substantially, and it can be dependent on the industry in which it operates. When using ROA as a comparative measure, it’s important to ensure the comparative figures are from the same industry.
ROA ratio provides the investors with a view of how effectively a company converts its investments on assets to net income. A company is said to be able to earn more income through its investments when the ROA ratio is high.
Calculation of ROA
ROA of a company is calculated by using the total assets in the company to divide the net income. It can be expressed as Net Income/Total Assets.
For example, two companies, A and B, invest in assets like plant and machinery, equipment, and more in the automobile industry. A’s investment sums up to $1500, and B’s investment comes to $13500. End of the year, the net income earned by both companies is $180 and $150, respectively.
ROA of the companies using the return on assets ratio formula:
A = 180/1600 = 11%
B = 1100/13500 = 8%
We can say that B has a more valuable business through the return on total assets formula. Still, A has an efficient business because it’s not just about earning profit but also about a company’s long-term existence.
Effective ROA Ratio
Once we calculate the return on assets ratio, how do we know where the company stands in terms of efficiency?
Industry experts say the ROA ratio of a company above 5% is considered good, and a ratio above 20% is considered excellent. But this is in general terms. When looking at ROA percentage, investors should also consider the company’s industry, market, customer base, and other factors that affect investment decisions in a company’s assets.
ROA as a Financial Ratio
A higher ROA may indicate a company is generating more profit against the total assets. On the contrary, a lower ROA means lower profits against the total assets.
Companies with higher ROAs tend to experience greater profits, while those with declining ROAs may struggle financially due to poor investment decisions.
As ROA also considers a company’s debt, a higher ROA in one year may say low debt, and a lower ROA in the next year may mean the company’s debt has increased.
Investing Decisions and ROA
ROA is considered one of the very useful financial ratios to analyze a company’s performance. Investors can use the return of assets interpretation to find stock opportunities because the ROA shows a company’s efficiency in using its assets to generate profits.
Comparing the ROAs of two companies can give the investor an idea of who will sustain longer in the advancing market.
Though ROA is considered a vital metric to compare companies, investors should also consider various other factors that affect a company’s performance. ROA alone may not give the perfect analysis of a company’s performance.
Different industries and their average ROA
|
Industry
|
Average ROA
|
|---|---|
|
Healthcare
|
7.97%
|
|
Transporation
|
6.91%
|
|
Consulting Services
|
51.43%
|
|
Retail
|
7.20%
|
|
Grocery Stores
|
33.50%
|
|
Tobacco
|
15.89%
|
ROA vs. ROE
Though ROE measures a company’s efficiency in utilizing its resources, a major difference between ROA and ROE is how a company’s debt affects the ratios.
ROA considers total assets, including the Capital of the company. This Capital figure would include any debt the company borrows. So ROA factor provides a view of how leveraged a company is.
ROE, on the other hand, considers a company’s equity, which excludes any liability. Thus, the company’s debt is out of the scene.
For any company, debt plays a major role. To analyze a company’s efficiency, we have to consider its debt and how well it can manage the debt with the net income, it has earned.
Issues with using ROA as an industry measure
A major setback in using ROA as an industry measure to compare companies is that the ROA ratio cannot be used across industries.
The ratio is more or less very specific to one industry, and we cannot compare a company’s ROA in one industry to that of another company in another industry.
The reason for this is those different companies have different asset bases. For example, the asset base of the clothing industry is different from that of the automobile industry. Sometimes recording the assets in the company’s books at historical costs rather than market value may lead to inaccurate analysis.
The Bottomline
ROA becomes an important financial metric for analyzing the efficiency and performance of a company in any industry. Though it illustrates a company’s net income as a percentage of total assets, it is not the only appropriate metric.
All investors should look at the overall picture when they compare different companies.
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