What is Return on Assets?
Return on Assets is one of the efficiency ratios used to measure and assess how efficiently the company’s assets are being used. The main indicators to measure the efficiency of assets in this ratio are Net Income and Total Assets.
Return on assets is calculated by using net income over the total assets that the entity uses to generate that income.
This ratio could be used in the company where assets are the primary resources used to generate revenue—for example, a manufacturing company or hotel.
However, this ratio is not suitable for assessing the company where assets are not the leading revenue generator—for example, consultant or services companies.
The formula of Return On Assets : Net Income / ( Total Assets)
- Finding the Net Income is not as hard as it is normally provided in the income statement. Net Income is normally at a specific period of time. If you do a benchmark by comparing the ROA of one profit centre, investment centre or company. It is a good idea to select the Net Income in the same period of time. Otherwise, your analysis is non-sense.
- For Total Assets, sometimes they use Average Total Assets. The most recommended is when the Average Total Assets are available, then it is recommended to select, but if it doesn’t, let use Total Assets. Whatever you use, there must be consistency.
What do I mean by that?
Let’s say you are comparing two investment centers of their Return on Assets. Then you should select the net income from the same period and the exact nature of assets, say Total Assets.
Okay, now you have learned about the formula and explanation of Return on Assets. Let move to the example together,
Here we go,
Example and Calculation:
The following is the example of Return on Assets and to calculate it.
ABC Company has Not Income: USD 50,000,000 for the period 1 January to 31 December 2016, and the Total Assets at the end of 31 December 2016 was USD100,000,000. The total Assets at the beginning of the year were USD 90,000,000.
ABC Company is operating in the manufacturing industry, and the Industry Average of ROA is: 1 Previous year, ROA of ABC Company was: 1.05.
Discuss ROA of ABC Company.
The ROA is Net Income / ( Total Assets) based on the formula. As per the scenario, the year’s total net income is USD 50,000,000. For Total Assets, in this case, we use Average Total Assets because the previous year’s Total Assets is available.
Average Total Assets is (USD 100,000,000/ USD 90,000,000)/2 = USD 95,000,000
Therefore, ROA = USD 50,000,000/ USD 95,000,000 = 0.52 or 52%
Return On Assets as Performance Measurement
This part will discuss the use of Return on Assets of Performance Management. This also includes the advantages and disadvantages of using ROA.
As mentioned above, Return On Assets is used to measure the efficiency of assets used to generate the Net Income. These are the Financial Indicators usually used in the manufacturing industry.
This Return on Assets usually is a benchmark with the industry average, competitor, and previous year. For better analysis, the trend of this ratio for at least three years would be more beneficial.
There are advantages and disadvantages of using ROA as a performance indicator to assess the company’s performance and reward management.
For the advantages, the ROA uses the percentage; therefore, we could compare it to the other companies with different asset sizes. ROA is also very to understand by non-accounting managers, and also it is straightforward to calculate.
Besides advantages, there are many disadvantages to using ROA as performance indicators. ROA uses accounting information for calculation, commonly affected by management judgment.
Accounting policies are one of those factors. ROA uses percentages but does not show the real value added to the shareholders or the company.
The severe disadvantages of ROA are that it motivates management to use the old assets and discourages them from investing in the new acquisitions.
Interpretation and Deep Analysis:
Now, let see how this ROA is mean to ABC Company.
Based on the calculation, the current ROA is only 0.52, while the previous year’s ROA was 1.05. Based on this ratio, we can say that the recent performance is poor than the last year in terms of efficiency ( using assets to generate revenue).
This might be because of low productivity, decreasing demand, or being highly competitive. However, compared to the industry average, ROA is 1, ABC Company is still not performing well enough.
There are many reasons why the ROA of ABC Company is decreasing. First, probably not all of the company assets are used.
Let say their many machines are idle assets due to the low purchase order or no technical personnel stand by to control those machines. These could cause the company to generate less profit than the previous year and the industry average.
Another reason is the accounting technique used by the management of the company. ROA is significantly affected by accounting policy, or it can simply mean management could trick on accounting policies to get the accounting result they want.
For example, Not income is affected by accounting depreciation mainly based on judgment.
An additional reason why the ROA of the company is decreasing is probably that this year, management has disposed of many of the old assets and replaced them with new ones.
This movement of assets could cause a large amount of depreciation being a charge to these years and result from decreased Net Income.
For better analysis and interpretation, all of the factors’ internal and external effects on the ROA should be included and considered, like demand in the market or ROA of industry average and competitors.
Internal factors like using old assets, replacing and changing accounting policies also significantly affect ROA.