Return on Assets (ROA) is a branch of the return on investment matrix. It shows the percentage of profit a company has generated over time in terms of its revenue. Also, it is one of the most important tools used to assess the managerial performance of a company.
ROA enables you to track how well the management of a company has generated income with its assets. More importantly, this can be done by juxtaposing the profits you’ve generated overtime with the capital you invested.
What Does Return on Assets Tell Investors?
In short, the sole aim of an investor is to make profits. Therefore, before an investor invests in a company, they checks the ROA of the company to know what their chances at profits are.
Some of the importance of ROA to an investor include the following:
- It saves the investor from making a bad investment. With ROA, the investor can look through the performance of a company and decide to invest or not.
- It helps the investor know the financial growth of the company. ROA tells investors how well a company can generate income from the assets they have. This in turn may dictate how well income might be made in the future or not.
On that note, you’ll agree with me that the return on assets tells an investor where and where not to put their money.
How to Calculate Return on Assets
Return on assets is calculated by dividing the net income (profits) the company has generated by the total assets of the company. The formula is expressed below:
ROA = Net Income/Total Assets
ROA = Return on assets
Net Income = profit made by the company after the company tax has been settled
Total Assets = The company’s capital or what it has
Net income, or profit as you may know, is a company’s or individual’s profit made after deducting the tax and other expenses. Also, the net income is referred to as the bottom line. This is because it’s usually spotted at the end of an income statement after all expenditures are made.
Business analysts in the UK regard net income as the profit given to shareholders. As a business owner, to calculate the net income for your business you’ll need to know the total revenue of your company. Lastly, you then subtract all expenses before tax to get your net income. Let’s see an illustration below.
Assume a company has $100,000 gross income (Gross income by the way is the total profit or pre-tax earnings). All expenses made by the company sum up to $30,000, they’ll be left with $70,000 as profit. Now if the taxable income they have to pay is 13% or $9100 (that is 13% of $70,000), then they’ll be left with a net income of $60,900 (that is $70,000 – $9100).
The total asset of a company is the sum total of the company’s assets. Assets have economic value that can generate income for the company. If this asset belongs to a business owner, then it is to appear in the balance sheet of the business.
Some Examples of Assets in a Company Include:
- Cash and cash equivalents
- Prepaid expenses
- Market securities
- Account receivables
- Intangible assets
- Fixed assets
Companies view their assets in order of priority, that is which of their assets can most rapidly be converted to cash.
There are basically two kinds of assets. They include:
- Liquid assets: These are assets that can readily be converted to cash.
- Illiquid assets: These are assets that can not be converted to cash easily.
One way to calculate your total asset is by the summation of total liabilities and owner’s equity.
Total Assets = Owners Equity + Liability
Here’s an example below:
Let’s say a company buys a piece of real estate worth $1,000,000 and they owe a $200,000 loan for the estate acquired. What will be the value of their total asset?
With the calculation above, the value of their total asset will be $1,200,000. Owners equity which is $1,000,000 and their loan $200,000.
Example of Return on Assets
Most times, the return of assets is used to compare businesses in the same sector. This is because different businesses have different forms of expenditures and so will have different ROAs. An illustration of two grocery stores.
- Macey’s Store
- Steve’s snack
|Macey’s Store||$5 million||$7 million||7.14%|
|Steve’s Snack||$10 million||$15 million||6.6%|
From the table above, you can see that Macey has been able to utilize their assets properly to make more ROA compared to Steve. And so we can say that Macey might be a better salesperson compared to Steve.
Using the ROA formula, which is Net income / Total assets, we were able to know who is better at utilizing their assets.
What Is a Good Return on Assets?
A good return on assets means that the company has made or makes more profits. Therefore, the higher the ROA of a company, the more profit they make, and the better their management.
Low Return on Assets
A low return on assets means that a business is depreciating in its income. This means that they aren’t able to make the most of their assets to generate profit. In short, having a low ROA shows that a company or business may be spending more than they make.
Therefore, a low ROA is regarded as bad for business as it does not show signs of growth for the company. As a result, the different ROA generated by various companies, having a suitable range for ROA may not be feasible.
However, if a company can generate a return on assets of about 5%, then it can be regarded as a decent amount. Anything about below a 5% increase is seen as a low ROA.
How Does Return on Assets Decrease?
There are various ways ROA can decrease. Some of which are:
Poor Management: As a business owner, you need to be particular about the management of your company. More importantly, this can be seen either with sales or properties. If proper management is not adhered to, chances are you may run down on your profit which will, in turn, affect the ROA of your company.
Inappropriate Expenses: This is why there is a need for a balance sheet. You need to learn to take account of whatever expenses you make. Otherwise, you may spend your profit thereby reducing your ROA. For businesses trying to meet up to an appropriate ROA, we advise that you avoid unnecessary expenses.
High Return on Assets
A high return of assets means that a company can make good profits with its assets. As stated earlier, due to the various businesses available ROAs tend to vary. But, if a business can generate more than 5% thereby making up to 20% on its ROA, then it can be regarded as a profitable ROA.
However, it is also possible for a business to make an unusually high ROA. When this happens, it could be a bad sign for the company which in turn may affect them in the long run. With an abnormally high ROA, it means that the company has not sold off their previous equipment and has allowed the value to depreciate.
And so in a bid to sell off, they probably may make an unusually high ROA. This may profit them in the short term but if not looked into, may affect them in the future.
How Do Companies Increase Return on Assets?
There are various ways a company can increase its return on assets. Some of which are:
Increase in Net Income: An increase in net income will automatically increase your ROA. To increase your net income, you need to reduce your asset cost (either market security cost, inventory cost, equipment cost, and the likes).
Reduced Expenses: When you cut down on expenses, you get to increase your revenue thereby increasing your ROA. There are so many ways you could cut down on your expenses. Negotiating with your supplier to reduce the cost of goods or get a new dealer is one way. Also, by reducing ship cost or you add it to your customer’s fee. These are a few ways you could reduce expenses.
Increase in Revenue: When it gets to increase in revenue, you’ll need to get creative. Look for ways to increase your revenue without adding to your cost. You could increase your revenue by improving your customer service thereby getting referrals which in turn leads to more sales. However, another way is by surveying the market space to see how you can diversify to make more profit.
What Is the Difference Between ROI, ROE, and ROA?
Return on Investments, Return on Equity, and Return on Assets are all financial ratios but, they do not all calculate the same thing. Let’s look a bit further at what differentiates them.
Return on Investment
Return on Investment (ROI) is used to evaluate the profitability and productivity of investments. Additionally, ROI can be used to compare how productive different investments are. Meaning, ROI is measured in percentage.
A high ROI shows that investment was profitable in contrast to its investment cost. In short, ROIs can be calculated by subtracting the cost of investment from the current value of investment and dividing by the cost of investment.
ROI = (cost of value investment – cost of investment) / cost of investment
The cost of value investment shows the dividend gotten from the investment of interest.
On the contrary, ROA is used to determine the progress of a company and how well it can liquidate its assets to cash and make profits.
Return on Equity
Return on Equity (ROE) measures the financial productivity of a company or the money the company generates based on individuals’ stake. Essentially, ROE can be used to measure the productivity of different companies.
This value is calculated by dividing the net income by the shareholder’s equity.
ROE = Net Income / Shareholders equity
In comparison, ROE deals with the productivity of a company based on its stake or shareholders. Whether as, ROA focuses on how well a company can generate income from the assets it has.
Return on Assets is an essential tool for both business managers and investors. The goal of any business owner is to attain a good ROA for their company which could serve as a trend for other businesses in the same sector. However, this may not be possible without a financial advisor.
As an investor, you’ll need returns on your investment and so a skilled financial advisor will help you make good choices. Also, same goes for a business owner. Additionally, you probably may have all the information about ROAs but little knowledge on how to apply them.
In conclusion, working with a skilled advisor will help you sift through the many bad investment choices out there and help you make good ROA.