Overview:
Increasing or maintaining return on assets is one of the most important tasks that need serious attention from senior management of most big corporate companies.
This is because of this ratio interested by the majority of shareholders, prospective investors, the board of directors, the management team, and staff.
Yet, a group of stakeholders who are mostly concerned about return on assets is shareholders.
These people want to know how efficiently the senior management of corporations manages their assets.
The higher ratio simply means the assets are well managed and a low ratio means the resources do not use efficiency compared to the industry as well as competitors.
The following are the four critical points that management of the company should fix to get the return on assets high or increase to the target points:
Get the idea from Formula:
Return on Assets = Net Income / Total Assets
+ a Net income is the net earnings for the period of time that we want to assess ROA. We can get the figure from the income statement.
+ Total Assets or an average of total assets are the net present value of assets at the end of the period. We also can get this figure from the balance sheet.
Based on the formula, two items affect the ROA ratio, Net income and Total Assets.
Improving net income will increase the return on assets ratio. And the decrease in total assets will also affect the balance.
1) Increase Net income to improve ROA:
There are many ways that an entity could increase its net income. For example, the entity could increase total sales for the period, and then net income will increase accordingly.
If 1000K of sales contributes to 10K net income, then increasing sales ratio will also boost net income ratio and do so ROA.
The cost of goods is one of the high costs that significantly affect net income. And keep the direct cost low is one of the most effective strategies that could improve gross profit margin and net income.
The entity might choose to increase the production volume to reduce the direct cost of products.
An entity might also need to review the operating costs to spend prices effectively.
For example, if the net profit ratio is 25%. 1$ save equal to 4$ sales. This explanation proves that keeping operating costs low is as essential as increasing sales.
Therefore, increasing net income is very important if the entity wants to increase ROA. And to increase net income, an entity should strictly review sales, cost of sales, and operating cost.
2) Decrease Total Assets to improve ROA:
As we mention above, ROA is the ratio that assesses the efficiency of using assets. In others, it compares how much an entity generates income from 1$ of assets compare to other entities or industry averages.
Now, let break down what it means by the efficiency of using assets.
As you should know, assets are the balancing items in the balance sheet. Assets equal to equity plus liability. Accounting standards classify those assets into current and fixed assets for user benefit.
Now let break down those assets and analyze what it means by the efficiency of investments.
3) Improve the efficiency of Current Assets:
Current assets consist of cash, receivable as well as inventories. The efficiency of using these assets could keep them low or let them generate additional income.
For example, an entity might make short-term cash investments to generate additional income. This will help ROA.
Receivables are also one of the most important current assets that an entity could manage to improve its ROA when low and short outstanding. Good credit policy and collection procedures could significantly help to improve this.
4) Improve the efficiency of Fixed Assets:
Expenses on fixed assets are not charged to income statements when they are purchased, but at times they are used based on the system basics.
Improving the efficiency ratio of using fixed assets could help the company increase its productivity or, in other words, reduce operating costs related to fixed assets.
Some companies consider operating leases rather than purchasing their fixed assets. However, this approach might lead to higher operating costs.
Conclusion:
Improving return on assets is an essential key performance indicator for the management team of most of the entities. And there are many ways that management could perform to improve its ROA.
These include increasing gross profit margin, net profit margin, and improving the efficiency of both current assets and fixed assets.
