Whether you're an investor, analyst or even an employee at a company, you're likely looking for a way to determine the success of a business in a way that's easy to understand.
While there's no perfect way to determine that, one that can be helpful and is commonly used is the return on assets (ROA) ratio. Using ROA to see how efficient a company's ability to make profit from its assets is can help you come to certain conclusions about whether to invest in a business, among other things.
So what is ROA, how is it calculated and how can it help you?
What Is Return on Assets?
Return on assets, often shortened to ROA, is the ratio that shows how efficiently a company gets a profit from the total assets it has. Using all the resources available to the company in the equation, you can see how the income the company makes relates to everything that goes toward it, and thus how effectively they are using those resources to make a profit.
Essentially, the return on assets is the percentage the profits are compared to the assets. And having that handy number available for a number of different companies you're interested in investing in can go a long way toward helping you make a decision.
The "assets" part of the ROA refers to a company's cash, cash equivalents, marketable securities, property, equipment and any other liability a given industry may have - and shareholder equity, the combined amount of debt and equity available to them.
Return on Assets Formula
By itself, the formula for calculating return on assets is simple. The formula is as follows:
Return on Assets = Net Income / Average Total Assets
You may need to do some additional math to get these figures if things change or if you don't have an income statement with you (that's the form that has a company's net income on it). Net income is a company's profit after factoring every expense in, including the cost of goods sold, taxes, employee salaries and benefits, office costs and any other expense.
Total assets will often have to be averaged out. They can be found on a company's balance sheet, but a company's total assets will have changed if, say, you check their 2017 balance sheet and 2018 balance sheet. To get that company's ROA for 2018, your best bet for accuracy is averaging those two figures and using that.
Examples of Return on Assets
Using data from Apple's Form 10-K as found on the SEC, at the end of the 2018 fiscal year Apple reported a net income of $59.531 billion. They reported total assets of $365.725 billion, but it also shows that at the end of 2017 they reported total assets of $375.319 billion. If we average the total assets out, that comes out to $370.522 billion.
From there, we can input the net income and total assets into the formula:
Return on Assets = $59,531,000,000 / $370,522,000,000 = 16%.
So Apple had a ROA of 16%. Another way of looking at that is that Apple made 16 cents in profit for every dollar they spent in assets.
Of course, if you're looking for new companies to invest in, you're probably looking for something without shares quite as costly as Apple. But this formula can be used for other companies as well. We can look at a different company with less costly shares.
Nordstrom (JWN - Get Report) released their most recent 10-K in February of 2019, reporting net income of $564 million. The total assets were reported as being worth $7.886 billion, while the February 2018 10-K reported $8.115 billion. These create an average total assets of $8.0005 billion. Thus:
Return on Assets = $564,000,000 / $8,005,000,000 = 7%
So in the last full fiscal year, Nordstrom made 7 cents of profit for each dollar in assets.
Return on Assets vs. Return on Equity
There are a variety of ways to gauge the profitability, efficiency and general financial success of a company. In addition to return on assets, another way you may have heard of is return on equity, also known as ROE.
While both ROA and ROE judge how efficient a company is at making a profit compared to its resources, where these percentages differ is the specific resources being used as a comparison point. Whereas ROA uses all total assets, ROE only uses shareholders' equity.
Calculations, then, are similar for each. Instead of dividing net income by average total assets, for ROE you would use average shareholder equity. If a company's balance sheet doesn't have the figure for the total shareholder equity, it can be calculated by subtracting the total liabilities from its total assets.
If we return to Apple's most recent 10-K, for 2018 they reported a total shareholder equity of $107.147 billion and a 2017 equity of $134.047 billion. This averages out to $120.597 billion. Dividing the net income by average shareholder equity, we have an equation of:
$59,531,000,000 / $120,597,000,000 = 49.4%.
That is a particularly high ROE; a ROE of around 15% would be considered healthy, and one that is 20% or higher would be good (though this may vary by industry).
Investors often use ROE to determine the likelihood of several factors. A high ROE could mean a better chance that a company gives out dividends, or that there is a high potential for growth.
Why Is ROA Important?
So what makes ROA matter in a separate way from ROE? Well, a return on assets includes shareholder equity as well, but it does so along with other assets and liabilities the company owns. ROE can be very important in determining how shareholders' money is being spent, but ROA can be a showcase for how well the company is making a profit compared to every last one of its resources.
Looking at a company's ROA from year to year can be very helpful in seeing whether a company has shown a pattern of efficiency over an extended period of time - and if they haven't, why they may not have. Perhaps a company's ROA has decreased each of the past two years. If they have made a substantial increase in assets but haven't seen a similar increase in income, maybe they're not using their resources as efficiently as you want from a potential investment.
If you're comparing two similar companies in the same industry, ROA can go a long way in helping you see which one might be the better choice. One company may have a higher net income, but the other one could have a higher ROA due to taking on less debt. This doesn't necessarily make one is a clearly better investment than the other. But many investors are looking for companies that have shown an ability to use their assets efficiently, as it can look to be a safer investment.
ROA is also important to know if you run a business, something you'll need to be aware of for a lot of decisions. Perhaps you, as a business owner, are interested in investing in a new piece of property for your business. How much is that going to increase the amount of liabilities your business has? Will the change it brings to your net income be enough to make it a worthwhile decision or is it going to be a blow to your company's ROA, and thus its ability to generate profit?
How Can ROA Differ by Industry?
ROA, when used as a comparison point, is best used when contained to one industry. In showing how to calculate ROA, we used Apple and Nordstrom as examples, but you wouldn't compare one to the other to prove their respective strengths or weaknesses, as they are incredibly different companies in different industries. You wouldn't glean much from either company doing this.
Some industries are inherently more asset-based than others. Industries that require companies to have a lot of machinery and factory equipment are inherently asset-heavy, and thus are more likely to have a lower ROA than companies that do not. Fixed assets like those cost money to purchase, repair and replace.
That by itself doesn't make these companies inefficient or poor investments. But it does mean you're better off comparing, for example, an airline with another airline to see how efficient it is, rather than comparing it to a company that has nowhere near the required assets. This way, you can see which airline is making a more efficient profit from its assets and proceed from there with your investment. If a high ROA is of particular importance to you when finding a new company to invest in, consider looking into industries that aren't as dependent on fixed assets.
Taking industry into account with ROA is of great importance for prospective investors. ROA can be a useful tool, but it needs to be applied well.
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