Use ROA To Gauge A Company's Profits

By Ben McClure AAA

Sure, it's interesting to know the size of a company. But ranking companies by the size of their assets is rather meaningless, unless one knows how well those assets are put to work for investors. As the name implies, return on assets (ROA) gauges how efficiently a company can squeeze profit from its assets, regardless of size. A high ROA is a telltale sign of solid financial and operational performance. (Read more, in ROA And ROE Give Clear Picture Of Corporate Health.)

Calculating ROA
The simplest way to determine ROA is to take net income reported for a period and divide that by total assets. To get total assets, calculate the average of the beginning and ending asset values for the same time period.

ROA = Net Income/Total Assets

Some analysts take earnings before interest and taxation, and divide over total assets:

ROA = EBIT/Total Assets

This is a pure measure of the efficiency of a company in generating returns from its assets, without being affected by management financing decisions.

Either way, the result is reported as a percentage rate of return. An ROA of, say, 20% means that the company produces $1 of profit for every $5 it has invested in its assets. You can see that ROA gives a quick indication of whether the business is continuing to earn an increasing profit on each dollar of investment. Investors expect that good management will strive to increase the ROA - to extract greater profit from every dollar of assets at its disposal.

A falling ROA is a sure sign of trouble around the corner, especially for growth companies. Striving for sales growth often means major upfront investments in assets, including accounts receivables, inventories, production equipment and facilities. A decline in demand can leave an organization high and dry, and overinvested in assets it cannot sell to pay its bills. The result can be financial disaster. (Find out more, in Earnings Power Drives Stocks.)

ROA Hurdles
Expressed as a percentage, ROA identifies the rate of return needed to determine whether investing in a company makes sense. Measured against common hurdle rates like the interest rate on debt and cost of capital, ROA tells investors whether the company's performance stacks up.

Compare ROA to the interest rates companies pay on their debts: if a company is squeezing out less from its investments than what it's paying to finance those investments, that's not a positive sign. By contrast, an ROA that is better than the cost of debt means that the company is pocketing the difference.

Similarly, investors can weigh ROA against the company's cost of capital to get a sense of realized returns on the company's growth plans. A company that embarks on expansions or acquisitions that create shareholder value should achieve an ROA that exceeds the costs of capital; otherwise, those projects are likely not worth pursuing. Moreover, it's important that investors ask how a company's ROA compares to those of its competitors and to the industry average. (Read Looking Deeper Into Capital Allocation for more information.)

Getting Behind ROA
There is another, much more informative way to calculate ROA. If we treat ROA as a ratio of net profits over total assets, then two telling factors determine the final figure: net profit margin (net income divided by revenue) and asset turnover (revenues divided by average total assets).

If return on assets is increasing, then either net income is increasing or average total assets are decreasing.

ROA = (Net Income/Revenue) X (Revenues/Average Total Assets)

A company can arrive at a high ROA either by boosting its profit margin or, more efficiently, by using its assets to increase sales. Say a company has an ROA of 24%. Investors can determine whether that ROA is driven by, say, a profit margin of 6% and asset turnover of four times, or a profit margin of 12% and an asset turnover of two times. By knowing what's typical in the company's industry, investors can determine whether or not a company is performing up to par.

This also helps clarify the different strategic paths companies may pursue - whether a low-margin, high-volume producer or a high-margin, low-volume competitor.

ROA also resolves a major shortcoming of return on equity (ROE). ROE is arguably the most widely used profitability metric, but many investors quickly recognize that it doesn't tell you if a company has excessive debt or is using debt to drive returns. Investors can get around that conundrum by using ROA instead. The ROA denominator - total assets - includes liabilities like debt (remember total assets = liabilities + shareholder equity). Consequently, everything else being equal, the lower the debt, the higher the ROA. (Read A Breakdown Of Stock Buybacks for more background information.)

A Couple Things to Watch For
Still, ROA is far from being the ideal investment evaluation tool. There are a couple of reasons why it can't always be trusted. For starters, the 'return' numerator of net income is suspect (as always), given the deficiencies of accrual-based earnings and the use of managed earnings.

Also, since the assets in question are the sort that are valued on the balance sheet - namely, fixed assets and not intangible assets like people or ideas - ROA is not always useful for comparing one company against another. Some companies are 'lighter', having their value based on things such as trademarks, brand names and patents, which accounting rules don't recognize as assets. A software maker, for instance, will have far fewer assets on the balance sheet than a car maker. As a result, the software company's assets will be understated, and its ROA may get a questionable boost.

Conclusion
ROA gives investors a reliable picture of management's ability to pull profits from the assets and projects into which it chooses to invest. The metric also provides a good line of sight into net margins and asset turnover - two key performance drivers. ROA makes the job of fundamental analysis easier, helping investors recognize good stock opportunities and minimizing the likelihood of unpleasant surprises.

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