What Is Return on Assets—ROA?
Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea as to how efficient a company's management is at using its assets to generate earnings. Return on assets is displayed as a percentage.
- Return on Assets (ROA) is an indicator of how well a company utilizes its assets, by determining how profitable a company is relative to its total assets.
- ROA is best used when comparing similar companies or comparing a company to its previous performance.
- ROA takes into account a company’s debt, unlike other metrics, such as Return on Equity (ROE).
The Basics of Return on Assets—ROA
Businesses (at least the ones that survive) are ultimately about efficiency: squeezing the most out of limited resources. Comparing profits to revenue is a useful operational metric, but comparing them to the resources a company used to earn them cuts to the very feasibility of that company's’ existence. Return on assets (ROA) is the simplest of such corporate bang-for-the-buck measures.
Higher ROA indicates more asset efficiency.
For example, pretend Spartan Sam and Fancy Fran both start hot dog stands. Sam spends $1,500 on a bare-bones metal cart, while Fran spends $15,000 on a zombie apocalypse-themed unit, complete with costume. Let's assume that those were the only assets each deployed. If over some given time period Sam had earned $150 and Fran had earned $1,200, Fran would have the more valuable business but Sam would have the more efficient one. Using the above formula, we see Sam’s simplified ROA is $150/$1,500 = 10%, while Fran’s simplified ROA is $1,200/$15,000 = 8%.
Return On Assets (ROA)
The Significance of Return on Assets—ROA
Return on assets (ROA), in basic terms, tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or against a similar company's ROA.
The ROA figure gives investors an idea of how effective the company is in converting the money it invests into net income. The higher the ROA number, the better, because the company is earning more money on less investment.
Remember total assets is also the sum of its total liabilities and shareholder's equity. Both of these types of financing are used to fund the operations of the company. Since a company's assets are either funded by debt or equity, some analysts and investors disregard the cost of acquiring the asset by adding back interest expense in the formula for ROA.
In other words, the impact of taking more debt is negated by adding back the cost of borrowing to the net income and using the average assets in a given period as the denominator. Interest expense is added because the net income amount on the income statement excludes interest expense.
Example of How to Use Return on Assets—ROA
ROA is most useful for comparing companies in the same industry, as different industries use assets differently. For example, the ROA for service-oriented firms, such as banks, will be significantly higher than the ROA for capital intensive companies, such as construction or utility companies.
Let's evaluate the return on assets (ROA) for three companies in the retail industry:
- Macy's (M)
- Kohl’s (KSS)
- Dillard's (DDS)
The data in the table is for the trailing twelve months as of Feb. 13, 2019.
|Company||Net Income||Total Assets||ROA|
|Macy's||$1.7 billion||$20.4 billion||8.3%|
|Kohl's||$996 million||$14.1 billion||7.1%|
|Dillard's||$243 million||$3.9 billion||6.2%|
Due to the increasing popularity of e-commerce, brick and mortar retail companies have taken a hit in the level of profits they generate using their available assets. Still, every dollar that Macy's has invested in assets generates 8.3 cents of net income. Macy's is better at converting its investment into profits, compared with Kohl’s and Dillard’s. One of management's most important jobs is to make wise choices in allocating its resources, and it appears Macy’s management is more adept than its two peers.
Return on Assets—ROA vs Return on Equity—ROE
Both ROA and return on equity (ROE) are measures of how a company utilizes its resources. Essentially, ROE only measures the return on a company’s equity, leaving out the liabilities. Thus, ROA accounts for a company’s debt and ROE does not. The more leverage and debt a company takes on, the higher ROE will be relative to ROA.
Limitations of Return on Assets—ROA
The biggest issue with return on assets (ROA) is that it can't be used across industries. That’s because companies in one industry—such as the technology industry—and another industry like oil drillers will have different asset bases.
Some analysts also feel that the basic ROA formula is limited in its applications, being most suitable for banks. Bank balance sheets better represent the real value of their assets and liabilities because they’re carried at market value (via mark-to-market accounting), or at least an estimate of market value, versus historical cost. Both interest expense and interest income are already factored in.
The St. Louis Federal Reserve provides data on US bank ROAs, which have generally hovered around or just above 1% since 1984, the year collection started.
For non-financial companies, debt and equity capital is strictly segregated, as are the returns to each: interest expense is the return for debt providers; net income is the return for equity investors. So the common ROA formula jumbles things up by comparing returns to equity investors (net income) with assets funded by both debt and equity investors (total assets). Two variations on this ROA formula fix this numerator-denominator inconsistency by putting interest expense (net of taxes) back into the numerator. So the formulas would be:
ROA variation 1:?Net Income + [Interest Expense*(1-tax rate)] / Total Assets
ROA variation 2: Operating Income*(1-tax rate) / Total Assets