What is Return on Assets (ROA)?
Return on Assets, also know as ROA is a financial ratio that helps you to analyse a company’s profit relative to its total assets. The ratio tells about the profitability of a company by comparing its net profit with its average total assets.
The ratio gives idea about a company’s management and how efficient they’re while using the company’s assets.
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Formula and Calculation of ROA
Return on assets (ROA) can be calculated by diving a company’s net profit by its total assets.
Return on Assets (ROA) = Net Profit/Total Assets
To calculate the return on assets, you need to figures, the net profit for the period (usually annual) and the company’s total assets.
Suppose a company posted a net profit of $20 million and its asset size stands on $100 million, then what will be the company’s Return on Assets (ROA)?
Return on Assets (ROA) = Net profit/Total Assets = $20 million/$100 million = 0.2 or 20% (in percentage term)
According to above result company has a ROA of 20%, this means the company earned 20 cents on every $1 of assets. The company will take 5 years to recover its assets, based on its profit.
Return on Assets Vs Return on Equity (ROA Vs ROE)
Both the ratios, return on assets and return on equity (ROE) are gauge of a company efficiency while using its resources. Generally, return on equity only gauge the return on a company’s equity, excluding its liabilities. This is the basic difference as return on assets (ROA) accounts for a company’s debt and ROE does not.
Preferred Return on Assets
The preferred return on assets of a company changes with change in the operating industry. For example, if a company from IT has a ROA of 12%, then you have to compare that company with its industry standard and how its peer companies are performing.
The ROA also changes with change in market scenario and change in fundamental data, taxation and other provisions.
Importance of ROA
- Return on assets includes shareholder equity, along its assets and liabilities of the company. In this way ROA gives better idea about a business’s efficiency, while analyzing a company.
- By comparing a company’s historical return on assets, investors gets better idea about the company’s profitability pattern and its growth over the period.
- ROA also helps a company’s management to analyze its profitability and growth, for its future prospects and decision making, while running the business.
- Return on assets also helps investors to compare a specific industry and find a better company in invest in with in a industry.
Limitations of ROA
- The biggest limitation of return on assets (ROA) is that it can not be used to compare companies from different industries. The reason is that companies in one industry, like IT industry have different asset size and percentage then the metal companies.
- ROA is suitable for sector specific, being mostly suitable for banking stocks, makes it limited.
- Return on assets works quite well, using it combined with several other fundamental tools like P/E ratio, P/B ratio, P/S ratio and more, but alone ROA is quite not a effective tool.
Return on assets (ROA) measures a company’s profit against the assets to generate income. It is also an important indicator to measure a company’s assets and its intensity. That means a lower ratio company is more asset-intensive, and vice versa.
With some important application, while doing fundamental analysis of a company most analysts uses the return on assets (ROI).