Business managers use the return on assets ratio to determine the profitability of all funds invested in their businesses. While ROA is a measure of profitability, it is different from the return on equity ratio and has other implications for managers and investors.
What Is ROA?
ROA is the ultimate measure of how much after-tax profit a company is making on every dollar invested in the business. It takes into consideration every asset in the business: cash, buildings, inventory, vehicles, intellectual property, machinery, equipment and receivables. ROA is of particular interest to shareholders because they want to know how much money they are making on their investment. ROA is a broader gauge used by investors and managers to determine how efficiently they are using the company's assets to make a profit.
What Is the Formula?
To calculate ROA, divide annual net profits by average total assets:
ROA = Net Profit/Average Total Assets
While the calculation of ROA is a ratio, it is typically presented as a percentage. The amount of a firm's assets can vary over a year, so it's better to use the average total assets for the calculation. To determine the average total assets of a company, add the company's assets at the beginning of the year to its assets at the end of the year and divide by two.
Meaning of ROA
Management's objective is to achieve an ROA in excess of the firm's interest cost of borrowing and the cost of equity capital. If a company borrows money at an interest rate of 8 percent and is able to achieve a 15 percent ROA, then it is ahead by 7 percent. In this case, management is doing a good job employing the firm's assets.
How to Use ROA
A company's ROA has to be compared to other firms in the same industry to know if its ROA is good or bad. When comparing the ROAs across various industries, it is important to consider the type of business and the amount of assets required. For example, trucking companies have a high investment in assets because they need fleets of large trucks, so these companies will have low ROAs. Software firms that sell programs to download will not have a high amount of fixed assets and their ROAs will be much higher. Advertising agencies are another example of companies that have low assets and high ROAs.
A company with an abnormally high ROA could be a bad sign. It might signal that the company is letting the condition of its equipment run down and not investing in new machinery and equipment. While this strategy will raise ROA in the short term, it will hurt the firm's long-term return on its assets as the productivity of its equipment declines. In general, firms with ROAs less than 5 percent have high amounts of assets. Companies with ROAs above 20 percent typically need lower levels of assets to fund their operations.
ROA is a vital analytical tool for investors and business managers. Achieving a reasonable ROA is a critical goal for a company, and it will be actively monitored for trends and performance relative to other businesses in the same industry.