Understanding Return on Assets (ROA)

What is Return on Assets (ROA)?

The Return on Assets (ROA) ratio assesses how well a company can manage its assets to generate profits over time. Since the main objective of a company’s assets is to generate revenue and profits, this accounting ratio assists management and investors. It assists in determining how well the company can convert its asset investments into earnings. A higher return on investment (ROI) implies that a company is more effective and productive in managing its balance sheet to generate profits. While a lower ROA suggests that there is space for development. Owing to the same asset base, it is always advisable to compare the ROA of companies in the same industry.

Return on Assets (ROA) Formula

The formula for the Return on Assets is:

Return on Assets = Net profits / Total Assets

Where,

Net Profits = Total Revenue – Cost of Goods Sold – Non-Operating Expense – Interest – Taxes

Total Assets = Current Assets + Non-Current Assets (Tangible Fixed Assets + Intangible Assets)

How to Calculate Return on Assets?

Illustration on Calculation of Return on Assets is:

Particulars	Amount
Net Profit	Rs 12,00,000
Interest Expense	Rs 2,00,000
Current Assets	Rs 26,00,000
Net Fixed Assets	Rs 38,00,000
Intangible Assets (Goodwill and Patent)	Rs 18,00,000
Total Assets Current Assets + Non-Current Assets Non-Current Assets= (Tangible Fixed Assets + Intangible Assets)	Rs 82,00,000 (Rs 18,00,000 + Rs 28,00,000 + Rs 18,00,000)
Return on Assets (Net profits / Total Assets)	14.63% (Rs 12,00,000 / Rs 82,00,000)

Interpretation of Return on Assets (ROA)

A higher ratio is more appealing to investors since it demonstrates that the company is better at managing its assets to generate more net income. A rising profit trend is usually indicated by a positive ROA ratio. Various businesses use assets differently. ROA is most relevant when comparing companies in the same industry. 

A falling ROA could suggest that a company has made poor capital investment decisions. Moreover, it isn’t making enough revenue to cover the cost of those assets. A falling ROA could suggest that the company’s earnings are dropping as a result of lower sales or revenue.

Return on assets is a measurement that can be used to determine how asset-intensive a business is. If a company has a higher return on assets then the company is less asset intensive. Such as software industry, service or knowledge based businesses. If a company has a lower ratio then the company is more asset intensive. The companies in manufacturing, construction, mining, etc sectors are usually asset intensive. A business with a return on assets of less than 5% is termed asset-intensive. A company with a return on assets of more than 20% is not asset concentrated.

Variation of Return on Assets

Debt – The financial structure of any company might comprise of debt and related interest payments during a financial year. To calculate the relevant return earned on assets it is prudent to remove the effect of such interest payments. Moreover, many analysts consider a post tax interest effect to calculate net profit. These are the variations of the Return on Assets

Formula

Return on Assets = [Net profits + Interest Expense * (1 – Tax Rate)] / Average Assets

Average Assets = (Total Assets at the Beginning of the Period + Total Assets at the Beginning of the Period) / 2

Illustration on Variation of Return on Assets

Particulars	Amount
Net Profit	Rs 12,00,000
Interest Expense	Rs 2,00,000
Tax Rate	20%
Total Assets As On 1st April 2021	Rs 78,00,000
Total Assets As On 31st March 2022	Rs 82,00,000
Average Assets (Total Assets at the Beginning of the Period + Total Assets at the Beginning of the Period) / 2	Rs 80,00,000 (Rs 78,00,000 + Rs 82,00,000) / 2
Net Profit Pre Interest [Net profits + Interest Expense * (1 – Tax Rate)]	Rs 13,60,000 [Rs 12,00,000 + Rs 2,00,000 * (1-0.20)]
Return on Assets [Net profits + Interest Expense * (1 – Tax Rate)] / Average Assets	17% (Rs 13,60,000 / Rs 80,00,000)

Importance of Return on Assets

Usually each of these companies should require roughly the same proportions of assets to sales in order to deliver goods and services to customers. Hence, the return on assets ratio can be used to analyse the efficiency of utilisation of assets within an industry. However, a business’s asset base may change significantly among industries. Hence, ROA should not be used to compare businesses in various industries. An asset-intensive manufacturing facility’s return on assets would not be similar to a consulting company’s return on assets.

The ROA illustrates how efficiently a company uses its assets to make profits. The investors can use it to locate stock possibilities.

A rising return on assets signifies that the company is gaining profits with each rupee invested. A declining ROA shows that the company has over-invested in assets that have failed to generate revenue growth. This would in turn indicate that the company is in difficulty. ROA can also be utilised to establish comparable comparisons between companies in the same industry or sector.

Limitations of Using Return on Assets

• Across Industries – ROA is not applicable to all industries. This is because organisations in different industries have diverse asset bases. As a result, companies in the tele-communications industry do not have the same asset base as those in the automobile industry. 
• Total Assets – The denominator’s total assets figure is from a single point in time or a balance on a particular date. Due to a major asset acquisition or sale, the asset total on that date could be quite different from the regular asset balance. The total assets figure could be inflated or deflated as compared to the assets prevalent during the year.  As a result, analysts usually consider either an average of opening and closing balances for a period or a weighted average across 12 months.
• Net Profit – Management has the ability to manipulate the net profit amount. They could put off some discretionary spending in order to boost revenues. Alternatively, a company can inflate the revenue by adding incorrect or unrealistic sales or services. They could also outsource asset-intensive operations (like production) to lower their overall asset investment.
• Trend – The results of the ratio must be viewed as a trend over financial periods. A trend of rising or falling ROA will help understand the true performance of the company. Moreover, the return on assets must be coupled with other profitability ratios to make any investment decisions.

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