Return on Asset (ROA) is a financial analytical tool that shows efficiency of the company’s operation in terms of assets.
This gives clues on how efficiently a firm is operating its assets in order to make profits.
The most important use of RAO is to compare among different firms or industries involving efficiency and financial soundness of operations.
Defining the Return on Assets (ROA) Ratio
ROA ratio gives a percentage figure of how much of a company’s total asset value is actually providing profit or profit-making capability.
It answers the question which “seeks to determine to what extent the company is utilizing its assets to produce earnings.”
The implication of a higher ROA is good use of resources or assets acquired by the business.
Formula for ROA
The formula to calculate ROA is: Net Income / Total Assets
Where:
- Net Income: The amount of money generated through operations of the company which is subjected to tax and company’s expenses.
- Total Assets is the sum total of current assets and noncurrent assets as brought out on the balance sheet but based on values.
For example, if in a company total asset are standing at $10million and net incomes are $1 million the ROA of the company could be calculated as,
This means out of every $1 invested the company can raise 10%.
Benefits of ROA
1. Is Improving Organizational Effectiveness
- ROA shows company’s effectiveness of the resources at its disposal in an effort to generate profits and exposing issues for improvement.
2. Facilitates Comparisons
- Most useful when one wants to compare companies from the similar sector.
- Enables comparisons to be made against industry mean.
3. Gives a roadmap to investors
- Potential shareholders apply ROA to determine if a firm is worth investing in especially in the manufacturing industries.
4. Underpins Strategy Development
- ROA is used by management in decision making regarding allocation of resources to maximize available capital and reduce underutilized assets.
5. Highlights Asset Productivity
- ROA shows how effectively the company’s assets are utilized, this is particularly important for companies, which invest much in fixed assets.
Uses of ROA
1. Evaluating Profitability
- As with ROE; ROA assists in determining the profitability of the company in relation to the assets it holds.
2. Assessing Financial Health
- ROA is a measure desired to always be high; it affirms good financial condition and efficiency in utilizing assets.
3. Comparing Across Industries
- Because ROA measures how efficiently assets employed in business operations are used, it is especially useful in comparing companies in industries such as manufacturing.
4. Monitoring Performance Across Time
- Analyzing ROA for several years allows us to track development and changes in the efficiency of assets.
5. Decision-Making in Mergers and Acquisitions
- This is because ROA is very important in evaluating the value of possible acquisitions.
Factors Affecting ROA
- Asset Intensity: Bigger asset values owned by some firms give them lesser ROA compared with many service industries possessing almost negligible assets.
- Revenue Growth: Higher level of revenue on the other hand give better revenue asset ratio if asset level still remains constant.
- Depreciation: The choice of the accounting method for assets; Total Asset value and Return on Asset may be affected.
- Leverage: High levels of debt would mean that many organizations would register low net income due to interest costs thus lowering ROA.
Examples of ROA Calculation
Example 1: A Manufacturing Company
Company A has:
- Net Income: $500,000
- Total Assets: $5,000,000
Example 2: A Service Company
Company B has:
- Net Income: $200,000
- Total Assets: $1,000,000
While possessing lower net income Company B has improved ROA, which indicates that the company has better ability to utilize its assets than Company A.
Limitations of ROA
1. Industry Differences
- Industry assessments show that RQA differs greatly between industries making cross-Industry assessment rather pertinent.
2. Impact of Asset Valuation
- Other practices like depreciation when applied in the valuation of the assets are agreeably influential in distorting ROA.
3. Emphasis on the Current Scientific Productivity
- As the name suggests, ROA focuses on current performance rather than the future’s revenue-generating ability of assets.
4. Ignores External Factors
- Information on economic factors that affect profit making and market forces is concealed in ROA.
Improving ROA
1. Increasing Revenue
- Increase sales by the influence of sales promotion and product development.
- On the other hand, vertical growth is the expansion of an organization’s product portfolio breadth in an attempt to offer its current and various new clients more products so as to capture them.
2. Reducing Costs
- Eliminate as much wasteful costs as possible.
- Adopt meager power usage technologies.
3. Optimizing Asset Utilization
- Sell off non-performing assets.
- Financial tip: Buy stocks that will pay high dividends.
4. Managing Debt Levels
- Lowering of debt means that the interest burden is brought down hence increasing the net income and as well as the rate of return on assets.
Real-World Application of ROA
1. Investors
- From the analysis of the above formula, investors are able to determine the efficiency of the management of assets as well as the profitability of companies.
2. Management
- Business managers rely on ROA in the assessment of operational strategies, and distribution of resources in the company.
3. Analysts
- Financial analyst employs ROA in rivalry company analysis within the similar industry and for investment advice.
Conclusion
The return on assets (ROA) is one of the crucial financial measures that help to evaluate how effectively a company manages assets to generate revenues.
ROA however, still remains a powerful tool to be used by both investors, management and analysts despite its limitations.
It also helps stakeholders make right decision involving with its technique, promises and usage for the sake of increasing its growth and profitability.
Frequently Asked Questions
1. What is a Good ROA Value?
A good or “good” ROA largely depends on the industrial classification of the firm. Manufacturing industries for instance may book lower ROA’s than service industries.
2. What Are the Benefits of ROA?
- Operational Efficiency: Reveals an ability of a business in managing its assets.
- Comparative Analysis: Essential that is used while comparing the companies operated in similar industries.
- Investment Insight: Helps investors to analysis of profitability.
- Strategic Decisions: This way it assists the management to determine the best way to use the assets available.
3. How does ROA differ across industries?
Business with large number of fixed assets like the utility industries normally post a lower ROA than an industry that is in the service industry because the later has fewer assets most of the time.
4. Can ROA Be Negative?
Yes, if the net income value is below zero then the ROA is also below zero meaning the company is making a loss.
5. How to Increase ROA for Companies?
- A few key ways of achieving targets include: improving sales performance in order to generate more sales revenue.
- Decrease expenses for increase in the net income in the organization.
- Enhance the utilization of the company’s assets by selling some of the low-turning assets.
6. What Are the Limitations of ROA?
- Asset Valuation: Select methods for handling assets in accounting determine ROA.
- Short-Term Focus: May choose not to consider future growth prospects.
- Industry-Specific Differences: Limits cross-industry comparisons.