The return on assets, also known as return on investment, is a ratio that indicates how profitable a company is in relation to its assets. A small business owner arrives at the percentage of return on assets by dividing the annual earnings with the total business assets. This figure depicts how well a business is managing its assets and converting these assets into net income. An increase in the percentage of return on assets is an indication of profitability for a business.
One of the reasons for an increase in the percentage of return on assets is control of business expenses. When a business earns more than it is spending, it can expect to improve and even increase its return on assets. However, this is not always a simple task to undertake because spending less may decrease sales volume. A good approach is to invest in those assets or undertake those expenses that are extremely necessary for business operation. This necessity is determined by the needs of the business at any given time.
Increased Asset Turnover
Asset turnover is the amount of sales generated by an asset. An increase in asset turnover entails increasing sales with the same number of assets or maintaining sales with a reduced number of assets. This approach is possible when a firm refrains from spending too much on exorbitant equipment or purchasing too much inventory. By leasing or renting equipment or outsourcing some jobs, a business is able to maximize its asset turnover.
An increase in sale, while lowering expenses, may increase the percentage of return on assets. Increasing sales to impact on ROA requires a proportionate reduction in expenses. Increasing the cost of goods sold while maintaining the current assets may also increase the percentage of ROA. For example, if by increasing the cost of goods to $500 and keeping expense at $7,500, the sales volume could increase to $10,000 then, you would add $2,000 to net profit and the ROA would increase to 6.4 percent.
Debt capital is the money borrowed from lenders and investors as a loan or venture capital. Debt capital is an asset and how a business invests this asset has a significant impact on the return on asset figures. Ideally, an increase in the percentage of return on assets means that a company has invested its debt capital wisely. When a company pays more to finance debt capital than it is getting from investing this debt capital, the return on asset is low.