Return on Assets (ROA)

Return on asset (ROA) measures how profitable entity’s assets are. It determines how much income or profit is generated for each dollar invested in entity’s assets. As this ratio compares the return generated by the investment, it a simple method to analyse how efficient the investment is generating cash inflows. Return on asset is also known as return on investment (ROI) or return on total assets.

Return on asset ratio is commonly calculated using the following formula:

Return on Asset (ROA) = Relevant returns
Average total assets

Above is more of a generic ratio in which relevant returns can either be of the following:

  1. net profit
  2. profit after tax
  3. Profit after tax + Tax adjust interest expense
  4. Operating income or Profit before interest and tax (PBIT)

Its up to management or the user of information to decide which income type should be used. For ordinary shareholder the relevant income can be profit after tax as it is only this amount of return available to him generated by entity’s assets. In this case formula can be:

Return on Asset (ROA) = Profit after tax
Average total assets

For management on the other hand, the relevant income can be operating profit as they would be interested in return generated by the assets for entity’s shareholders and debt holders. The formula in this case will be:

Return on Asset (ROA) = Operating profits
Average total assets

The better yet can be profit after tax plus tax adjusted interest expense as entity would like to know returns generated by assets for both shareholders and debt holders. We are adding profit after tax and tax adjusted interest expense as management has bought entity’s assets from funds give by shareholders (that earn dividend thus profit after tax) and lenders, bond holders (that earn interest thus interest expense).

Return on Asset (ROA) = Profit after tax + [Interest expense x (1-tax rate%)
Average total assets

It is important however, that whatever method is used to calculate ROA it must be used on consistent basis. As switching from one method to the other may cause distortion in the results. For example using operating profits instead of profit after tax may result in higher ROA.

This ratio needs information from income statement and statement of financial position. Income related figures are taken from income statement whereas for average total calculation, we need current and prior year’s total assets figure or in other words opening and cloing total assets. Formula for average total asset calculation is:

Average total assets = Total assets ending last year + Total assets ending current year

Analysis and Interpretation

As mentioned earlier, ROA measures the profit generated for each dollar of investment in assets therefore, higher the ratio the better it is. ROA ratio can improve if either or both:

  1. relevant income used for ratio increases
  2. Average total assets decrease

Increasing ROA means that entity is able to exploit its assets better. It also means that management is efficient in managing the resources available at its disposal and able to generate more cash flows with lesser or same capital invested.

Entity’s profits can increase by lower the expense burden or increase the overall revenue of the entity. If entity is able to generated higher income, it will be most probably translate in higher ROA. Most notable strategy is to lower entity’s gearing which will lower the interest expense burden on profits. This is one of the reasons why entities may prefer raising finance by issuing additional shares instead of issuing debt instruments.

Emphasizing again that even switching from profit after tax to operating profits figures for ROA purposes may result in higher ROA even if denominator stays the same. That is why entities must stay consistent with factors used for ROA metric.

Decreasing total assets of entity is probably an extreme measure as it is hardly the case if entity would sell assets just to improve ROA. However, selling inactive assets, switching to leased assets under operating lease or shifting to activities that are less asset intensive will certainly reduce overall assets and may cause increased ROA.

However, better ROA as a result of reducing assets may be an unfavourable sign for entity. For example, if entity’s assets lose value as a result of impairment or revaluation, it may for the time being improve ROA but its an indication that entity is relying on obsolete assets and soon its profitability can suffer. Therefore, users must be cautious and keep an eye on other relevant factors too as in this case its actually the opposite what ROA is supposed to tell.