Companies use the return on assets (ROA) ratio to determine whether they are earning enough money from capital investments. These investments might include things such as building facilities, land, machinery and fleet vehicles. Managers and analysts use the return on assets ratio as a measure of performance. Comparisons between industrywide and internal prior year ratios might indicate a need for a company to use its assets more efficiently.
Accountants and asset managers calculate the return on assets ratio by dividing the company's income before interest and taxes by its net assets. The calculation yields a percentage figure or ratio. For example, if a company has an annual income of $100,000 and net assets of $500,000, its return on assets is 20 percent. In other words, the company receives a 20 percent return or 20 cents on every dollar it invests in assets.
A low percentage return on assets indicates that the company is not making enough income from the use of its assets. In some cases, a low percentage return may be acceptable. For instance, if a firm recently purchased an expensive piece of machinery for one of its manufacturing plants, the return on that asset may be low for the first few years of operation. If the return remains low beyond the first few years, it may indicate an unwise investment on the part of management. The machinery may not be increasing production efficiency or lowering overall production costs enough to positively impact the company's profit margin.
Low percentage return on assets may indicate an inefficient use of company facilities, machinery or fleet. This is especially true if the return on assets percentage is lower than the industry average. For example, the company may own too many fleet vehicles that spend more time sitting in parking lots than hauling manufactured goods. Another possibility is that the fleet vehicles are outdated and cost too much to maintain. Long-term or capital leases that cost more per square foot than the company yields in sales per square foot is another example of an inefficient use of company assets.
When a company consistently produces a low return on assets percentage, it may indicate a problem with its strategic management. The company may be expanding too quickly. If it purchases too much land, buildings and equipment, its assets and capital expenditures rapidly increase. This might backfire if actual sales and income do not meet management's growth projections. Management may also use the company's assets poorly if it inappropriately disperses its production facilities and responsibilities. Consolidation or the integration of several functions, such as warehousing and order fulfillment, may be a more efficient solution.