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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. Return on assets is displayed as a percentage and its calculated as:

ROA = Net Income / Total Assets

Note: Some investors add interest expense back into net income when performing this calculation because they'd like to use operating returns before cost of borrowing.

Sometimes, the ROA is referred to as "return on investment".

BREAKING DOWN 'Return on Assets - ROA'

 

In basic terms, ROA 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 against a similar company's ROA.

Remember that a company's total assets is 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. An analyst that chooses to ignore the cost of debt will use this formula:

ROA = (Net Income + Interest Expense) / Average Total Assets

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. Let's evaluate the ROA for three companies in the retail industry - Macy's, J.C. Penney, and Sears. The data in the table is for the fiscal year ended January 28, 2017.

Company Net Income Total Assets ROA
Macy's $611 million $19.85 billion 3.08%
J.C. Penney $1 million $9.31 billion 0.011%
Sears $ –2.22 billion $9.36 billion –23.72%

Due to the increasing popularity of e-commerce, brick-and-mortar retail companies have taken a hit in the level of profits they generate using their available assets. Every dollar that Macy's invested in assets in 2016 generated 3 cents of net income. On the other hand, every dollar used to purchase assets in Sears translated into a 24-cent loss for the company. Sears' negative ROA coupled with its high total debt of $13.19 billion means that the company is receiving little income, even though its investing a high amount of capital into its operations. Given that the company is not generating any positive income per invested capital, this investment might not be a good option for investors.

It appears that Macy's is better at converting its investment into profits, and J.C.Penney may need to re-evaluate its business strategy as it's ROA is very low. When you really think about it, management's most important job is to make wise choices in allocating its resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.

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.

Are you ready to use ROA in your trading strategies? Check out -- ROA and ROE Give Clear Picture of Corporate Health and Use ROA to Gauge Company’s Profits.

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