What Is Return on Assets (ROA)?
Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea as to how efficient a company's management is at using its assets to generate earnings.
ROA is displayed as a percentage; the higher the ROA is, the better.
- Return on assets (ROA) is an indicator of how well a company utilizes its assets in terms of profitability.
- ROA is best used when comparing similar companies or by comparing a company to its own previous performance.
- ROA does not take into account a company’s debt, while return on equity (ROE) does—if a company carries no debt, its shareholders' equity and its total assets will be the same and ROA would equal ROE.
Return On Assets (ROA)
Understanding Return on Assets
Businesses (at least the ones that survive) are ultimately about efficiency: squeezing the most out of limited resources. Comparing profits to revenue is a useful operational metric, but comparing them to the resources a company used to earn them cuts to the very feasibility of that company's existence. ROA is the simplest of such corporate bang-for-the-buck measures.
Return on Assets=Total AssetsNet Income
Higher ROA indicates more asset efficiency. For example, pretend Spartan Sam and Fancy Fran both start hot dog stands. Sam spends $1,500 on a bare-bones metal cart, while Fran spends $15,000 on a zombie apocalypse-themed unit, complete with costume.
Let's assume that those were the only assets each firm deployed. If over some given period Sam had earned $150 and Fran had earned $1,200, Fran would have the more valuable business but Sam would have the more efficient one. Using the above formula, we see Sam’s simplified ROA is $150 / $1,500 = 10%, while Fran’s simplified ROA is $1,200/$15,000 = 8%.
The Significance of Return on Assets
ROA, in basic terms, tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or a similar company's ROA.
The ROA figure gives investors an idea of how effective the company is in converting the money it invests into net income. The higher the ROA number, the better, because the company is earning more money on less investment.
Because of the balance sheet accounting equation, note that total assets are also the sum of its total liabilities and shareholder's equity. Both of these types of financing are used to fund the operations of the company. Since a company's assets are either funded by debt or equity, some analysts and investors disregard the cost of acquiring the asset by adding back interest expense in the formula for ROA.
In other words, the impact of taking more debt is negated by adding back the cost of borrowing to the net income and using the average assets in a given period as the denominator. Interest expense is added because the net income amount on the income statement excludes interest expense.
Example of How to Use Return on Assets
ROA is most useful for comparing companies in the same industry, as different industries use assets differently. For example, the ROA for service-oriented firms, such as banks, will be significantly higher than the ROA for capital-intensive companies, such as construction or utility companies.
Let's evaluate the ROA for three companies in the retail industry:
The data in the table is for the trailing 12 months as of Feb. 13, 2019.
|Retail Sector Stocks|
|Company||Net Income||Total Assets||ROA|
|Macy's||$1.7 billion||$20.4 billion||8.3%|
|Kohl's||$996 million||$14.1 billion||7.1%|
|Dillard's||$243 million||$3.9 billion||6.2%|
Every dollar that Macy's invested in assets generated 8.3 cents of net income. Macy's was better at converting its investment into profits, compared with Kohl’s and Dillard’s. One of management's most important jobs is to make wise choices in allocating its resources, and it appears Macy’s management, in the reported period, was more adept than its two peers.
Return on Assets (ROA) vs. Return on Equity (ROE)
Both ROA and return on equity (ROE) are measures of how a company utilizes its resources. Essentially, ROE only measures the return on a company’s equity, leaving out the liabilities. Thus, ROA accounts for a company’s debt and ROE does not. The more leverage and debt a company takes on, the higher ROE will be relative to ROA.
Thus, as a company takes on more debt, its ROE would be higher than its ROA. By taking on debt, a company increases its assets thanks to the cash that comes in. Assuming returns are constant, assets are now higher than equity and the denominator of the return on assets calculation is higher because assets are higher. ROA will therefore fall while ROE stays at its previous level.
Limitations of Return on Assets
The biggest issue with ROA is that it can't be used across industries. That’s because companies in one industry, such as the technology industry, and another industry, such as oil drillers, will have different asset bases.
Some analysts also feel that the basic ROA formula is limited in its applications, being most suitable for banks. Bank balance sheets better represent the real value of their assets and liabilities because they’re carried at market value (via mark-to-market accounting), or at least an estimate of market value, versus historical cost. Both interest expense and interest income are already factored in.
The St. Louis Federal Reserve provides data on US bank ROAs, which have generally hovered around or just above 1% since 1984, the year collection started.
For non-financial companies, debt and equity capital is strictly segregated, as are the returns to each: interest expense is the return for debt providers; net income is the return for equity investors. So the common ROA formula jumbles things up by comparing returns to equity investors (net income) with assets funded by both debt and equity investors (total assets).
Two variations on this ROA formula fix this numerator-denominator inconsistency by putting interest expense (net of taxes) back into the numerator. So the formulas would be:
- ROA variation 1: Net Income + [Interest Expense*(1-tax rate)] / Total Assets
- ROA variation 2: Operating Income*(1-tax rate) / Total Assets
Frequently Asked Questions
What do you mean by return on assets (ROA)?
Return on assets, or ROA, measures how much money a company earns by putting its assets to use. In other words, ROA is an indicator of how efficient or profitable a company is relative to its assets or the resources it owns or controls.
How is ROA used by investors?
Investors can use ROA to find stock opportunities because the ROA shows how efficient a company is at using its assets to generate profits.
A ROA that rises over time indicates the company is doing a good job of increasing its profits with each investment dollar it spends. A falling ROA indicates the company might have over-invested in assets that have failed to produce revenue growth, a sign the company may be in some trouble. ROA can also be used to make apples-to-apples comparisons across companies in the same sector or industry.
How can I calculate a company's ROA?
ROA is calculated simply by dividing a firm's net income by total average assets. It is then expressed as a percentage.
Net profit can be found at the bottom of a company's income statement, and assets are found on its balance sheet. Average total assets are used in calculating ROA because a company's asset total can vary over time due to the purchase or sale of vehicles, land or equipment, inventory changes, or seasonal sales fluctuations. As a result, calculating the average total assets for the period in question is more accurate than the total assets for one period.
Note that there are alternative methods for arriving at ROA as well.
What is considered a good ROA?
ROAs over 5% are generally considered good and over 20% excellent. However, ROAs should always be compared amongst firms in the same sector. 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.