Return on assets is a metric or profitability ratio indicating how efficiently a company utilizes its assets. In other words, the ratio depicts the capability of a company to generate profits using its assets.
It is depicted in percentages. The higher the percentage, the better a company is utilizing its resources towards making profits. A lower percentage means a firm should focus on improving its operations.
All companies have two major types of assets, i.e., tangible and intangible assets. Land, building, vehicles, and cash are some of the tangible assets of a firm. While patents, trademarks, IPs, etc., are intangible ones.
It is vital to note that companies with high tangible assets will usually have a low ROA, and firms with high or more intangible assets will have a high ROA compared to others. It is because capital-intensive companies will have to spend more on maintaining and acquiring assets. A considerable part of their revenue covers tangible assets' costs.
Why is ROA important?
One of the significant indicators that differentiate a company from another is efficiency. A more efficient business will always be successful in attracting investors and building a good public image.
Understanding the ROA of a company is crucial because investors wish to know how well a company can convert its assets into earnings.
Moreover, a lower return on assets helps a company look at its deficiencies and work on them accordingly.
Hence, return on assets is a crucial indicator of how a company is performing that further helps in achieving success by taking corrective actions on time.
How to calculate ROA?
The formula to calculate the ROA of a company is a simple procedure, as the data to do it lies in the company's financials.
The formula is:
ROA= (Net Profit / Total Assets) * 100
SEBI has made it mandatory for most public companies to publicize their financial data, such as net profits, income statements, balance sheets and total assets. If you wish to calculate a company's return on assets ratio, you can easily use the data provided by companies earning reports.
Example
For example, there are two companies. AC ltd and YZ ltd. The net profit of company AC ltd is ₹ 1,00,000 and YZ ltd is ₹2,00,000. The total assets of company AC are ₹ 10,00,000. At the same time, YZ has ₹ 25,00,000 worth of total assets.
Let's say you wish to invest in one of the two companies mentioned above. Which company will you select? Well, you have to calculate the ROA of both companies. Let's figure it.
ROA of AC ltd: (₹ 1,00,000 / ₹ 10,00,000) * 100 = 10%
ROA of YZ ltd: (₹ 2,00,000 / ₹ 25,00,000) * 100 = 8%
From the above calculation, it is clearly seen that AC ltd is more efficient in converting its assets into earnings than YZ ltd. Even though the earnings of YZ are higher than AB ltd, hence, you should consider investing in efficient companies.
Advanced formula to calculate ROA or Returns on assets formula
The value of a company's assets varies over time. Hence to compute the actual ROA that considers changing asset values is necessary. That is why experts have come up with this advanced formula for calculating ROA:
ROA = (Net profits / Average assets) * 100
Since it takes the average value of the firm's assets instead of its actual value, you get more accurate and reliable results.
What is a good ROA to consider?
A ROA of 5% or more is decent enough to judge the efficiency of a company. If the percentage is 20% or more, it is considered excellent.
However, one vital point to note is that you must compare the ROA of a company with another company only if they fall under the same industry.
Let's say the returns on asset ratio of a company in the manufacturing industry is 6%. And the ROA of a company in the tech industry comes out to be 15%. If you compare both of them, you may think investing in the tech industry is better. But if you peek into reality, most firms in the manufacturing industry have a ROA of 5%, and industries in the tech sector usually have a 20% ROA or more.
The results can be misleading if you compare two different industries that are not competitors.
ROA vs ROE
Return on equity is another important indicator to analyze a company's performance and is often confused with ROA. However, both of them are different parameters.
The return on equity of a company is an indicator of how effectively a company generates earnings using the funds put in by shareholders. It is calculated by dividing net income by the total equity of the shareholders.
However, return on assets signifies how well a company is able to increase revenue using its total assets.
The main difference between ROE and ROA is how the company's debt is taken into account. Shareholder equity and the total assets of the business will be equal in the absence of debt. Its ROE and ROA should be equal, too, logically.
Drawbacks of ROA
It is a narrow concept. ROA is a good indicator of how a company uses its assets. It does not cover other aspects of the business.
Investors and analysts need to analyze a company from a bigger point of view and analyze a company after considering other parameters as well. A company's overall performance can be analyzed by calculating its ROA, ROE and ROI.
Moreover, you can use it to compare companies across different industries. Hence it is limited in its application.
Conclusion
Return On Assets is a good indicator of judging a company's performance and the abilities of the management.
However, its use is limited and needs a clear understanding of the company's overall performance. Different formulas to calculate ROI make it even more confusing to comprehend.
Hence, it is advisable to use other metrics, such as return on investment and return on equity, along with ROA, to avoid misleading results.