Business, Legal & Accounting Glossary
Net income for a specific time divided by total assets, often used to measure profitability.
Return on assets is defined as net income divided by average total assets for the period.
Return on assets is a measure of the efficiency of a company. How well does the company use its assets to generate profit?
ROA = \frac{net\ income}{\frac{Total\ assets\ beginning\ of\ period + Total\ assets\ end\ of\ period}{2}}
However, it can be broken down further to get a better look at what is happening in the company.
ROA = \frac{Net\ income}{Total\ sales} * \frac{Total\ sales}{Avg\ total\ assets} = Net\ margin * Asset\ turnover
What this allows you to do is to discover strengths and weaknesses at the company. If the net margin is high, but asset turnover is low, ROA will be low. This is especially good to see when comparing the company against its peers. If two companies have the same net margin but different ROAs, then the difference must be that one company is using its assets more efficiently than the other to generate sales.
Contrariwise, if a company wishes to improve its ROA and it finds that its asset turnover is close to industry norms while its net margin is lower, then the net margin should be what it works on.
One can also check this component analysis to see if a company’s announcement that it is cutting expenses actually makes sense. For instance, if the company’s net margin is at or even above industry norms, but its ROA is below, the company would do better to improve asset turnover, maybe by upgrading some of its assets (such as manufacturing plants) to more modern, efficient ones.
Let’s look at Nike’s ROA for 2003 – 2005:
| Year | ROA | Profit Margin | Asset Turnover |
| 2003 | 7.1% | 4.4% | 1.61 |
| 2004 | 12.8% | 7.7% | 1.66 |
| 2005 | 14.5% | 8.8% | 1.65 |
You can see from this that the company didn’t really improve how much revenue its assets were generating (on a dollar-for-dollar basis), but that they improved their profit margin, thereby becoming more efficient overall.
Instead of using net income, some analysts calculate it using EBIT * (1 – tax rate). (EBIT = earnings before interest and taxes, a.k.a. operating income.) The tax rate is often standardized, either overall or for an industry.
Return on assets is net income divided by total assets.
Thus if net income is $100,000 and total assets are $1,000,000, return on assets is 10%.
Return on assets is often computed as net income divided by average assets ((beginning assets + ending assets)/2), because net income is generated continuously through the period, not only on the last day.
Also, note that return on assets calculates the return on all capital, from both creditors and owners — unlike return on equity, which includes only owners’ capital.
Return on assets is more revealingly if less efficiently, computed as Net Margin (net income/sales) X Asset Turnover (sales/assets).
Because sales appear in both numerator and denominator, the equation reduces to net income/assets, ie, return on assets.
The first part of the return on assets equation shows how much profit the company can wring from each sales dollar.
The second part of the return on assets equation shows how efficiently the company can generate revenue from the assets it has. Both higher profitability and higher efficiency yield a better return on assets.
Over the last 10 years, that company has averaged a ROA of 12.25%.
A good way to compare the financial health of banks is to look at their return on assets percentage, since most of their holdings will be in cash or cash equivalents.
ROA
Asset turnover
Net income
Profit margin
Return on equity
Investors often look for the magic number or metric that will identify a great stock out of the universe of all stocks.
This magic number doesn’t exist.
However, when you are considering stocks to buy, there are certain metrics and numbers that are more important than others.
They can’t be used as the sole qualifier to determine great stocks, but you can use them to eliminate poor performers.
You must always look at the big picture when considering a stock and that means considering a number of metrics.
Return on Assets is one of the handful of really important metrics every investor should know.
Return on Assets (ROA) tells you how efficiently (or inefficiently) a company turns assets into net income. It is a way to tell at a glance how profitable a company is.
Consider that companies take capital from investors and turn it into profits, which are in turn returned to the investor in one form or another.
ROA measures how efficiently the company does this.
Obviously, the more efficient a company is in converting assets (capital) into profits, the more attractive it will be to investors.
That’s about as simple as it comes: companies that make more money for the owners are worth more than companies that don’t make as much money.
ROA is made up of two components: net margin and asset turnover. When used together, these two metrics tell an important story.
First, a quick review. Net margin is found by dividing net income by sales. Net margin reveals what percentage of each dollar in sales and company retains.
Companies that wring lots of profit out of each dollar of sales have a big advantage, but it is not the final answer.
The other component is asset turnover, which gives you an idea of how well a company does in producing sales from its assets. You find asset turnover by dividing sales by assets.
Once you have net margin and asset turnover, multiply them together to determine ROA. You now have an idea of how well a company can convert assets into profits. Companies with high ROA compared to their peers are more efficient at using assets to generate profits.
You can calculate ROA for yourself or you can use one of the Web sites that has done all the math for you. One site that offers ROA is Morningstar.com.
Even if you don’t do the calculations yourself, it is important to know how the numbers are generated.
ROA shows how companies have two choices in improving efficiency.
Companies can raise prices and create high margins or rapidly move assets through the company. Either way (or both) improves ROA.
It is important to compare companies in the same industries. Some industries traditionally have higher margins or asset turnover than other industries do.
ROA is an important measure to use and understand, but its flaw is that the metric does not consider the effect of borrowed capital.
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This glossary post was last updated: 28th November, 2021 | 0 Views.