Definition:
Return on average assets is the profitability ratios that used to assess the profitability that an entity could earn or generate from the average of total assets for the period of time.
This ratio use entity’s net income for the period of time that analyst want to assess and then compare to average of total assets.
Return on average assets is not much different from return on assets. This ratio is good for the investor if we could compare to competitor performance with the same size, others financial and non-financial data, budget, or assets forecasting.
Formula:
Return on average assets = Net income / Average of total assets
- Net income is the net profit that an entity earns during the period. Normally this income reporting in the entity income statement. Net income that uses for calculation usually after profit and tax.
- Average total assets refer to the value of assets on average between the value of assets at the beginning of the period and the value of assets at the end of the period. This period must be consistent with the period of net income above. For example, if net income is covered in a period of three years, the average of total assets should also cover the period of three years as well. That means we should use the value of assets from the first year plus the second year plus the third year to average those total value.
- The ratio is normally calculated as the percentage and to make sure that the interpretation is useful for users, others ratio, and related non-financial data should also consider.
Example:
For example, Acom is the bank and the net income that the bank generates for the last three years is USD 3,000,000. The recorded total assets of the banks for three years are 5,000K, 5900K, and 7500K consistently.
The bank want to assets what is its return on average total assets for the accumulation of three years.
Calculation:
Based on scenario above we have,
- Net income for three years 3,000K
- Average of total assets = 6,133K
Based on the formula above, return on average assets = Net income / Average total assets
Then, Average total assets = 3,000/6,133 = 48%
The ratio seen to be high since it is almost 50% of net income that entity could generate from its total assets in average amount $6,133K.
However, to make sure if this perform really that good, we should compare the ratio again others banks at the same size. We should also assess what are the others factors that could lead this ratio become that high.
Advantages:
There certain advantages for users, investors, and management use this ratio for performance assessment especially focus on the efficiency of using and managing assets to add value to the entity at the maximum capacity.
This ratio is not only easy for calculation but also help the users that do not have the financial background to get a better understanding of the result.
All information that use for calculating this ratio is normally available in the entity financial statements.
For example, net income can be found in the income statement and the total value of assets of each period could be found in the balance sheet. This ratio is present as a percentage that is very easy for users to understand.
Disadvantages:
Even though there is a number of advantages for users of financial statements to get benefit from a return on average assets, this ratio also has a number of disadvantages that the related stakeholders should understand and be aware of.
Here is the list:
- Use financial data to calculate. Financial data can be manipulated by the management team if they wish too. For example, the depreciation rate might not reflect what it should be for certain assets.
- Difficult to compare entity with different size. This ratio is recommended to compare with the competitor with the same size only.
- Use net income to calculate which not more relevance to assets is.
