What is the Return on Assets (ROA)?
The Return on Assets (ROA) is a profitability metric that measures the efficiency at which a company can utilize its assets to generate more net earnings.
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How to Calculate ROA
The term ROA stands for Return on Assets and is a commonly used metric for tracking how efficiently a company can put its assets to use to produce more net profits.
The more value that a company can extract from the assets on its balance sheet, the more efficient the company operates since its assets are being utilized at near full capacity to maximize profits at the net income level (i.e. the “bottom line”).
If management can allocate resources well, the profitability of the company tends to increase as fewer expenses and capital expenditures are required to achieve a certain level of output.
Generally, all companies should attempt to maximize the output level with the required spending kept at a minimum – as achieving this means the company is operating near full capacity and efficiency.
The ROA of a company is calculated by dividing the company’s net income by its average total assets, as expressed below.
- Return on Assets (ROA) = Net Income / Average Total Assets
Furthermore, the calculated ROA is then expressed in percentage form, which allows for comparisons among peer companies, as well as for assessing changes year-over-year.
At its core, the ROA metric answers the question:
- “How much is the company earning in net income for each dollar of assets owned?”
The numerator, net income, comes from the income statement, while the denominator, the balance of the average assets, comes from the balance sheet.
Note the mismatch in timing – i.e. the income statement covers a specific period but the balance sheet is a snapshot at one specific point in time – hence, the average between the beginning and ending balance of the total assets in a given time period is used in the formula.
How to Interpret Return on Assets (ROA)
Simply put, companies with consistently higher ROAs can derive more profits using the same amount of assets as comparable companies with lower ROAs.
Therefore, high ROA companies are more likely to perform well over the long run and become market leaders with higher profit margins.
- For companies with a ROA higher than comparable companies, it can be reasonably assumed that the company’s assets are being used near full capacity, or at the very least, used more efficiently than its industry peers.
- On the other hand, a lower ROA relative to the industry average can be a red flag indicating that management might not be deriving the full potential benefits from the assets it owns.
For the ROA to be useful in comparisons, the companies must be in the same (or similar) sector, as industry averages vary significantly.
But besides comparisons to industry competitors, another use case of tracking ROA is for tracking changes in performance year-over-year.
- If ROA is rising over time, that suggests the company is improving on its ability to increase its profits with each dollar of asset owned.
- If ROA is declining, this indicates the company might have purchased too many assets and/or is failing to utilize its assets to their full capacity.
Return on Assets (ROA) vs Return on Equity (ROE)
The relationship between ROA and ROE is directly related to the topic of debt financing.
Unlike ROE, the ROA does not factor in debt in a company’s capital structure. For companies carrying no debt – i.e. all-equity firm – its shareholders’ equity and its total assets will be equivalent (and ROA and ROE would be equal).
But if those companies were to raise debt capital, their ROE would rise above their ROA from the increased cash balance, as total assets would rise while equity decreases.
ROA Calculator – Excel Model Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Return on Assets Model Assumptions
For our modeling exercise, we’ll be assuming the following operating assumptions.
Balance Sheet Assumptions (Year 1)
- Cash & Cash Equivalents: $20m
- Accounts Receivables (A/R): $40m
- Inventories: $60m
- PP&E, net: $120m
Here, we’ll assess two different scenarios, which we can toggle between in the “Case” cell (L3).
- Upside Case
- Downside Case
With Year 1 as our starting point, we’ll assume the following year-over-year changes on the B/S.
Upside Case Assumptions
- Cash & Cash Equivalents: +$4m
- Accounts Receivables (A/R): $0m – No Change
- Inventories: –$2m
- PP&E, net: –$4m
If the active case is set to “Upside”, the “Total Current Assets” increases from $150m in Year 1 to $158m by the end of Year 5.
Under the same time horizon, the “Total Assets” balance decreases from $270m to $262m.
The takeaway is that the current asset balance is trending upward, but the cause of the positive +$8m change is caused by the cash balance increase, not inventories.
Regarding the fixed assets base (i.e. the PP&E), the decline of $16m implies fewer capital expenditures are required.
As for the other case, if we set the active case to “Downside” instead, the signs in the “Step” column are each flipped.
Downside Case Assumptions
- Cash & Cash Equivalents: –$4m
- Accounts Receivables (A/R): $0m – No Change
- Inventories: +$2m
- PP&E, net: +$4m
The net impact is the “Total Current Assets” declines from $150m in Year 1 to $142m in Year 5 – a total decrease of $8m.
For the “Total Assets” line item, the balance increases from $270m in Year 1 to $278m in Year 5.
The increase in PP&E sitting on the B/S can be interpreted as increased CapEx spending, which is often caused by lackluster growth and/or increased competition in the market.
ROA Calculation Example
Now, all that we need to complete our return on assets (ROA) calculations is the net income assumptions.
Income Statement Assumptions
- Net Income in Year 1 = $25m
- Upside Case YoY Change = +$2m
- Downside Case YoY Change = –$2m
Under the “Upside Case”, net income increases from $25m to $33m, whereas in the “Downside Case”, net income declines from $25m to $17m.
By dividing the net income in each period by the average balance between the prior period and current period “Total Assets” balance, we can calculate the ROA for the projection period.
The formula for calculating the return on assets (ROA) is shown below.
For the “Upside Case”, ROA increases from 10.0% to 12.5% – which implies more efficient resource allocation, causing increased net earnings.
The decline in inventory signifies faster inventory turnover from increased customer demand, and the declining PP&E means more value is being created by the existing fixed assets with minimal CapEx spending requirements.
However, in the “Downside Case”, ROA declines from 8.5% in Year 1 down to 6.1% – with the opposite changes (and implications) on the B/S and I/S.
In closing, the ROA metric can be used by investors to grasp a better understanding of how efficient a company is at converting its asset purchases into net income.
The higher the ROA number, the more operationally efficient the company is at generating more profits with fewer investments.