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Investors can use various profitability ratios to evaluate a company’s performance. These may include several metrics, one of which is the Return on Assets (ROA) ratio.
What is the Return on Assets ratio?
The Return on Assets (ROA) ratio indicates a company’s profitability in relation to its total assets. It gives investors or stakeholders an idea of how efficiently a company uses its assets to generate profits. Similarly, it can show the company management’s efficiency in handling its operations. The ROA ratio comes in the form of a percentage.
A higher ROA ratio represents more efficiency from a company’s management in handling its assets. Similarly, it may be an indicator of higher profitability. On the other hand, a lower ROA ratio shows the company management’s failure to generate profits. However, the ROA ratio is usually a relative metric and not an absolute one. Therefore, investors need to look at it comparatively rather than individually.
How does the Return on Assets ratio work?
For companies, success comes in the form of efficiency. If these companies utilize their assets efficiently, their profits will also increase. It is because assets are usually a scarce resource for them. Therefore, efficiently managing and maximizing the use of their assets is a priority for every business.
While most profitability ratios compare a company’s profits to its revenues, the ROA ratio can also be beneficial. It is another way of evaluating a company’s profitability. Typically, it is a useful method to compare a company’s performance with its historical information or similar companies. It can also help investors in comparing companies of different sizes.
By comparing the ROA ratio of companies of varying sizes, investors can measure their relative profitability. For example, a smaller company with lower profits may use lesser assets compared to a large one. As mentioned, however, these companies must be of similar natures for the comparison to be meaningful.
How to calculate the Return on Assets ratio?
Investors can use the Return on Assets formula to calculate the ratio. It is as below.
Return on Assets = Net Income / Total Assets x 100
The above represents the basic formula for calculating the ROA ratio. Net income refers to a company’s net profits, usually found at the bottom of its Income Statement. Similarly, total assets represent the sum of a company’s current and non-current assets found on the Balance Sheet. Some investors may also use the average total assets of a company. Therefore, the formula will be as follows.
Return on Assets = Net Income / Average Total Assets x 100
The above formula can help calculate the ROA ratio of a company with fluctuating total assets. It represents the average of the opening and closing total assets of a company.
Example
A company, Red Co., had a net income of $50,000. The company’s opening assets at the start of the period were $200,000. Similarly, its closing assets were $300,000. Therefore, the company’s Return on Assets will be as follows.
Return on Assets = Net Income / Average Total Asset x 100
Average Total Assets = ($200,000 + $300,000) / 2 = $250,000
Return on Assets = $50,000 / $250,000 x 100
Return on Assets = 20%
Conclusion
The Return on Assets ratio is a profitability metric used to calculate a company’s efficiency in generating profits. Companies need assets to be profitable. Therefore, by comparing their profits with their total assets, investors can calculate their efficiency.
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