Think of Return on Assets (ROA) as a measure of efficiency. Companies with high ROAs are better at sweating Assets for higher Profits.
Return on Assets (ROA)
ROA tells an investor how much Profit or Return a company generated for each Rupee of Assets.
Formula for Return on Assets
ROA = Earnings/Assets Alternatively, this can also be expressed as ROA = (Earnings/Sales) x (Sales/Assets), or
ROA = Net Margin x Asset Turnover
The first component of Return on Assets is simply Net Margin, or Net Income divided by Sales. It tells us how much of each Rupee of Sales a company keeps as Earnings, after paying all the costs of doing business.
The second component is Asset Turnover, or Sales divided by Assets, which tells us roughly how efficient the firm is at generating Revenue for each Rupee of Assets.
Multiply these two, and we have the formula for Return on Assets.
Utility Value of Return on Assets
ROA helps us understand that there are two routes to obtain excellent operational profitability. The company can charge high prices for its products (high margins) or it can turn over its assets quickly.
When using ROA as a comparative measure it is best to compare it against a firm’s previous ROA numbers or the ROA of a similar company. ROA for public companies can vary substantially and will be highly dependent on the industry.
Calculating Return on Assets
Calculate ROA by simply dividing Profit after Tax (annual earnings) by Average of Total Assets. Calculate Average Total Assets for any fiscal period by adding Total Assets for the fiscal and the previous fiscal and divide by two. Profit after Tax can be taken from the Profit and Loss Statement from the firm’s Annual Reports. The firm’s Total Assets can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Total Assets refers to all the resources a company has at its disposal – the shareholders capital plus short and long term borrowed funds.
Rough benchmarks for analysing a firm’s ROA
All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned Rs. 20 for each Rs. 100 in assets. As a general rule, anything below 5% is very asset-heavy [manufacturing, railroads], anything above 20% is asset-light [advertising firms, software companies].
You may also like to learn more on other returns-linked profitability measures as below.