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\n Return on assets (ROA) is a measure of how efficiently a company uses the assets it owns to generate profits. Managers, analysts and investors use ROA to evaluate a company\u2019s financial health.
\nReturn on Assets: What Is ROA?
\nReturn on assets compares the value of a business\u2019s assets with the profits it produces over a set period of time. Return on assets is a tool used by managers and financial analysts to determine how effectively a company is using its resources to make a profit.
\nIf that sounds abstract, here\u2019s how ROA might work at a hypothetical widget manufacturer. The company owns several manufacturing plants, plus the tools and machinery used to make widgets. It also maintains a stock of raw materials, plus unsold widget inventory. Then there are its unique widget designs, and the cash and cash equivalents it keeps on hand for business expenses.
\nCollectively, these are the widget manufacturer’s assets. The money the company earns from selling widgets minus the cost of materials and labor equals its net profit. Divide the company’s net profit by the value of its assets to get ROA.
\nHow to Calculate ROA
\nIt’s simple to calculate ROA, as we saw above: Divide a company\u2019s net profit by its total assets, then multiply the result by 100.
\nROA = (Net Profit / Total Assets) x 100
\nPublic companies report net profit on their income statements, and disclose their total assets on their monthly, quarterly, or annual balance sheets. You can find these statements in a company’s quarterly earnings reports.
\nLet\u2019s say our widget manufacturer reported a net profit of $2.5 million in 2020, and total assets at the end of the year of $38.5 million. To determine the company’s ROA for 2020, you would divide $2,500,000 by $38,500,000, giving you 0.064935. Multiply by 100 and round up to get a ROA of 6.49%. This tells you that for every dollar in assets owned by the widget company, they earn 6.49\u00a2 in profit.
\nAdvanced ROA Formula
\nA more sophisticated ROA calculation takes into account that the value of a company\u2019s assets changes over time. To factor this into your calculation, use the average value of assets the company owned in a given year, rather than the total value of its assets at year end.
\nOnce you’ve determined the average value of a company’s assets, divide net profit by average assets and multiply it by 100 to get the percentage.
\nROA = (Net Profit / Average Assets) x 100
\nTo continue the example from above, you would average the value of the widget manufacturer’s assets from 2020, discovering that its average asset value is only $33,500,000, lower than the total at the end of the year. When you divide the company’s net profit of $2,500,000 by $33,500,000, you get a ROA of 7.46%. This ROA is more accurate than the 6.49% figure in the example above.
\nHow to Use Return on Assets
\nROA is a helpful metric for gauging a single company\u2019s performance. When a firm\u2019s ROA rises over time, it indicates that the company is squeezing more profits out of each dollar it owns in assets. Conversely, a declining ROA suggests a company has made bad investments, is spending too much money and may be headed for trouble.
\nYou should be very cautious about comparing ROAs across different companies, however. ROA is not a useful tool for comparing different sized companies or companies that aren\u2019t in similar industries. Expected ROAs might vary even among companies of the same size in the same industry, but are at different stages in their corporate lifecycles.
\nFor these reasons, it’s best to use ROA as a way to analyze a single business over time. Plotting out the ROA of a company quarter over quarter or year over year can help you understand how well it\u2019s performing. Rising or falling ROA can help you understand longer-term changes in the business.
\nWhat Is a Good ROA?
\nAn ROA of 5% or better is typically considered good, while 20% or better is considered great. In general, the higher the ROA, the more efficient the company is at generating profits. However, any one company\u2019s ROA must be considered in the context of its competitors in the same industry and sector.
\nFor example, an asset-heavy company, such as a manufacturer, may have an ROA of 6% while an asset-light company, such as a dating app, could have an ROA of 15%. If you only compared to two based on ROA, you\u2019d probably decide the app was a better investment.
\nHowever, if you compared the manufacturing company to its closest competitors, and they all had ROAs below 4%, you might find that it\u2019s doing far better than its peers. Conversely, if you looked at the dating app in comparison to similar tech firms, you could discover that most of them have ROAs closer to 20%, meaning it\u2019s actually underperforming more similar companies.
\nROA vs. ROE
\nReturn on equity (ROE) is a similar financial ratio to ROA, and both can be used to measure the performance of a single company.
\nROE is calculated by dividing a company\u2019s net profits over a given period by shareholders’ equity\u2014it measures how effectively the company is leveraging the capital it has generated by selling shares of stock. If ROA examines how well a company is managing the assets it owns to generate profits, ROE examines how well the company is managing the money invested by its shareholders to generate profits.
\nInvestors use ROE to understand the efficiency of their investments in a public company. ROA\u2019s measure of a company’s efficiency in terms of assets complements the conclusions you can draw from ROE.
\nLimitations of ROA
\nThough ROA is a helpful calculation, it’s not the only way to measure a company\u2019s efficiency and financial health. A company\u2019s ROA is influenced by a wide range of additional factors, from market conditions and demand to the fluctuating cost of assets that a company needs. ROA should be used in concert with other measures, like ROE, to get a full picture of a company\u2019s overall financial health.
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