What Is the Return on Assets Ratio Formula?
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John Csiszar
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Melanie Grafil
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One of the many metrics that investors use when evaluating a company is return on assets. The greater the return a company can achieve using a given amount of capital, the higher the valuation that investors are likely to give it.
An Overview of the Return on Assets Ratio Formula
Return on assets is a measure of corporate efficiency. The more a company can earn relative to its total assets, the more productive it is. As companies that are more productive can generate more long-term profits, they are highly regarded by analysts and investors alike. But, how exactly can you calculate what a company’s return on assets is? Here’s all you’ll need to know about ROA.
Rate of Return on Assets Formula
The formula to calculate corporate rate of return on assets is quite simple. All you have to do to calculate it is divide a company’s net income by its total assets.
Example
Imagine that a company has $1 million in assets and generates $100,000 in net income. Dividing $100,000 by $1 million results in an ROA of 10%.
It’s important to note, however, that a company’s “total assets” isn’t the amount of cash it has in its bank account. It’s actually a more complicated calculation.
In accounting terms, total assets can be calculated in one of two ways. The first is by adding current assets and noncurrent assets and might include the following:
- Cash and accounts receivable
- Property
- Plant
- Equipment
- Inventory
- Intangible assets
The second way to compute total assets is to add a company’s total liabilities to its shareholder equity. While this might perhaps seem counterintuitive, thinking of the equation in another way makes more sense — to calculate shareholders’ equity, subtract total liabilities from total assets.
What Does a High Or Low ROA Mean?
In a general sense, a high ROA means that a company is very efficient, squeezing as much profit as possible out of every dollar of available capital. A low ROA means the opposite, indicating a company could be doing better at generating revenue from its assets.
However, ROA doesn’t exist in a vacuum, and it isn’t an absolute measure. Different industries, for example, tend to have different ROAs, so it can get tricky as an investor if you’re trying to compare two companies that don’t compete in the same field.
Some industries, for example, are considered “asset-heavy,” which makes it harder to generate an ROA above about 5%. Other sectors are “asset-light,” making it easy to post an ROA above 20%.
Industries that have higher ROAs are typically service-oriented, with fewer assets on hand. This makes it easy to boost ROA. Common examples include software companies, banks and consulting companies. Lower-ROA industries — which are typically asset-rich — include utilities and airlines.
Know the Industry
It’s best that you understand the type of industry a company is in before you analyze whether it has a high or low relative ROA. A utility company, for example, will never have an ROA approaching what a software company can achieve, so it’s impossible to make an apples-to-apples comparison. If you’re comparing two software companies, on the other hand, the one with the higher ROA might be the one you should consider investing in, all other factors being equal.
What Factors Affect the ROA?
A company’s return on assets are affected by numerous variables. In addition to the actual components of the ROA formula, ROA can be affected by both internal and external factors. Here’s a look at the components affecting ROA.
Income
As income is literally part of the ROA equation, it obviously plays a big role in affecting a company’s return on assets. The higher the income a company can generate, the higher its ROA will go.
Efficiency
Efficiency refers to how much profit a company can squeeze out of every dollar of its assets. For example, if a company can turn over its inventory rapidly or keep machinery and other productive assets from being idle, it maximizes its efficiency and increases its ROA.
Expense Control
The better a company can control its expenses, the more profit it will make. As profit — or net income — is the numerator in the ROA formula, it plays a direct role in increasing a company’s return on assets.
External vs. Internal Factors
Internal factors are one of the primary determinants of ROA. Internal factors include things like good management and high-quality products that are in demand. The economic factors listed above, including efficiency, revenue generation and expense control, also play an important role.
However, ROA can be affected by external factors as well. In an economic recession, for example, many companies suffer from a reduction in ROA, along with a shrinking of their profits. Government policies can also affect companies, especially in terms of tax policies or industry regulations. Inflation, interest rates, consumer confidence and numerous other external factors can also play a role in a company’s ROA.
How To Improve ROA
Improving any single component of the ROA formula will improve a company’s return on assets. Any combination of increased profitability or a reduced asset will boost ROA. Of course, each portion of the formula can be affected by a number of external and internal factors, as described above.
Final Take
Return on assets can be a key way to evaluate the performance of a company. However, ROA doesn’t exist in a vacuum. Even a high absolute ROA may not necessarily be “good,” if it’s low compared with the leaders in a particular company’s industry. Conversely, even a low absolute ROA may not necessarily be a bad sign, especially in an asset-heavy industry like utilities.
While a high ROA — on either an absolute or relative basis — may be a good indication of a company’s efficiency, ROA by itself isn’t the only factor that you should consider when choosing whether or not to invest in a company. Earnings growth, industry trends, company-specific news and macroeconomic factors should all play a role in your evaluation of companies.
FAQ
- What does return on assets tell you?
- Return on assets tells you how much income a company is generating relative to the size of its asset base. Investors often use this ratio to tell them how efficiently a company is operating.
- What is a good ROA ratio?
- A "good" ROA ratio can vary from industry to industry. Overall, a company that can generate an ROA above 5% is generally doing well, but this may not be the case in specific sectors. A well-run, asset-light company like a software business, for example, should have an ROA in the high teens or even above 20%.
- What is the significance of return on assets?
- Return on assets tells investors how efficient a company is at using its resources. Generally speaking, the higher the ROA, the better. A company that can generate a lot of profits on a given asset size may offer better investment potential than a competitor in the same field, as essentially it's an indication of profitability relative to a company's peers.
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- Corporate Finance Institute. "Return on Assets (ROA) Formula."
- FasterCapital. "Factors Affecting Return on Assets (ROA)."
