Return on Assets (ROA) is the amount of money a company earns or the profit it generates from the assets it has invested. It is basically how a company’s assets are profitable in generating revenue.
The total income of a company in a given period is divided by the average total assets in the same period, and the return on assets is determined.
The Return on Assets is expressed as a formula, as shown below:
Return on Assets (ROA) = Total Income
Total Assets
Companies are categorized in different industries, therefore different assets will generate different values of profits. Generally though, a higher ROA indicates that the management of the company is effective and productive in generating a profit using its assets.
A company should compare its ROA to other companies in the same industry. When using ROA to gauge performance, the company should give consideration to its asset base. That means that if it utilizes fixed assets of high value for its operations, it will have a lower ROA, since its assets will decrease net income by a higher margin. A company showing an ROA of 5% and above is considered to be performing generally well.
Importance of Return on Assets (ROA)
- A company can use Return on Assets to determine its performance compared to other companies in the same industry. It can also compare its performance from one period to another to gauge its consistency, improvement, or otherwise.
- Return on Assets is used by a company to determine how effectively it has used its assets to generate revenue. When the ROA is high, then the management of a company can safely conclude that they are employing efficiency in utilizing the capital invested in the assets to generate income. Every company wants to have its capital utilization optimized for high returns.
- Investors look into a company’s ROA and determine the success of the company in managing its assets to generate revenue. They are able to determine if a company is a good investment or otherwise, by comparing its ROA to other companies in the same industry. This is especially important when a company issues shares for potential investment.
Illustrations of Return on Investment
Illustration one
Company A has $20,000 in total assets and a net income of $4,000 generated.
Return on Assets (ROA) = Total Income
Total Assets
=4000
20000
ROA=0.2 or 20%
This means that Company A’s Return on Assets is good. Asset efficiency is high.
Illustration two
Company B has a net income value of $7,000 and assets valued at $100,000 at the beginning of the year. In the course of the year, it diversifies operations and closes the year with assets valued at $180,000.
The ROA here is calculated by first determining the average of the total assets since the asset value at the beginning of the year differs from the asset value at the end of the year.
Average Total Assets = Assets at the beginning of the year + Assets at the end of the year
2
=100,000+180,000
2
= 140,000
Return on Assets (ROA) is then calculated as:
Return on Assets (ROA) = Total Income
Total Assets
= 7,000
140,000
ROA= 0.05 or 5%
This means that Company B’s Return on Assets is good, though it could be improved.
In conclusion, Return on Assets gives shareholders a general view of the company’s efficiency in using its assets to generate profit.
