This is an ultimate guide on how to calculate Return on Assets (ROA) ratio with in-depth interpretation, analysis, and example. You will learn how to use its formula to evaluate a company's profitability.
Definition - What is Return on Assets Ratio (ROA)?
When you’re considering investing in a company, you want to feel confident that the business in question is performing effectively enough to generate the greatest returns possible, with the fewest assets.
By calculating a firm’s ROA, you can measure its net earnings against its total assets to determine just how successfully it’s using its resources to profit from its regular business operations.
Not only will this process allow you to judge how efficient a company’s management team is at generating earnings, it can also indicate just how capable the company is of funding its own growth and expansion.
Considering the fact that the entire purpose behind a firm’s assets is to produce revenue, the return on total assets ratio should play a critical role in your evaluation of any potential investment.
More...
Formula
So what is the return on asset formula? You can easily calculate a company’s ROA by using the following equation:
Return on Total Asset Ratio = Net Income / Total Assets
A company’s net, after-tax income can usually be found on its income statement for a given period, while its total assets amount is reported on its balance sheet.
Many investors prefer to average a firm’s total assets, since this amount can fluctuate over the course of a reporting year.
To do this, you would simply add the opening and closing annual asset amounts together, and divide by 2.
Read also: Return on Capital Employed - Formula, Example & Analysis
Return on Assets (ROA) Calculator
Example
Okay now let's have a look at a quick example so you can know how to find return on total assets ratio in real life.
Perhaps you are considering investing in Company FF, and you want to find out how efficiently its management team has been using company assets to turn a profit.
To calculate Company FF’s return on asset ratio for the past three years, you would use the given ROA formula and the appropriate figures from its balance sheets and income statements to devise a comparison, as follows:
Net Income | Total Assets | |
|---|---|---|
Year 1 | $1,000,000 | $5,000,000 |
Year 2 | $1,200,000 | $6,000,000 |
Year 3 | $1,400,000 | $6,500,000 |
From these results, you can see that Company FF has been steadily generating a positive return on its assets for the past several years.
Interpretation & Analysis
Now that you understand the ROA equation, let's find out how to use this ratio to analyze a company's profitability.
So what is considered a good return on assets?
A higher return on asset ratio is generally a more desirable outcome, since it means that a business is handling its resources more effectively in the production of income.
The higher the result of the ratio, the more profitable a company’s assets are.
In effect, you could simply consider a firm’s resources as a vehicle for converting investment dollars into profit.
You should bear in mind, however, that different industries have different asset requirements.
Those that rely heavily on expensive equipment, such as the construction industry, will demonstrate a very different return on assets ratio than those that operate with relatively few assets, like the consulting or marketing sectors.
It’s important to use this ratio to compare companies within the same industry, and/or to track a single firm’s profit trend over a period of time.
Cautions & Further Explanation
Calculating the return on total asset ratio for a given company relies on working with an accurate reckoning of its total assets.
But this amount is generally based on historical cost, and some companies hang onto their major assets, such as specialized equipment, for many years.
Because these types of material resources depreciate over time, the long-term portion of the asset figure may not be as precise as it should be, and it can effectively skew the results of the return on asset ratio calculation.
While most short-term asset amounts, such as inventory, can be assessed with relative accuracy, you may want to consider substituting a depreciated or current value for those assets that make up a large portion of a firm’s longer-term holdings.
