The financial statements of the business entities are just a starting point for the analysis of the company’s financial health. An investor cannot decide which organization is better to invest in due to differences in accounting methods, capital structures, business strategies, etc.
What is a viable way to determine a company’s financial health compared to other market competitors?
Financial ratios represent a company’s financial metrics so that it is easy to interpret and understand for decision making. Financial ratios provide a uniform ground to compare the financial health of different companies within the same industry.
There are many kinds of financial ratios to assess different financial metrics. The most common financial ratios are profitability ratios, liquidity ratios, leverage, efficiency, performance, and market ratios.
In this article, we will discuss return on net operating assets that is a performance ratio. The article will discuss formulas, uses, calculations, and examples of return on net operating assets.
What Is Return On Net Operating Assets?
Net operating assets represent the difference between operating assets and operating liabilities. The operating liabilities are calculated by reformatting balance sheets, and cash and financial assets are excluded from the total assets. The operating assets are calculated based on the operating approach.
Net operating assets are assets that a business entity uses to generate profit and perform day-to-day business operations. The business income can be derived from two sources: business operations and financial activities(investments). The investors would be interested in knowing the income prospects from business operations. Therefore, the return on net operating assets shows the amount of profit generated from business operations.
What Is Return On Net Operating Assets?
The operating profit of a business before tax represents its income from primary business operations. Therefore, the return on net operating assets represents the exact amount of profit generated by primary operations. The income from other sources is not part of a business’s operations; therefore, net income is not used for calculation.
We can formally define return on net operating assets as,
It is a rate of return representing the efficiency of a company’s net operating assets in generating income.
The return on net operating assets or RNOA is a performance ratio is calculated by dividing net operating profits by net operating assets. It represents the ability of a company to generate income from its net operating assets. You can regard return on net operating assets as an engineered version of return on assets.
Return On Assets Vs. Return On Net Operating Assets
As talked about earlier, return on net operating assets is a modified form of return on assets. Return on assets represents the net income generated by using the total assets available for a business. It also includes the income generated from financial activities.
Whereas return on net operating assets is a more conservative approach to measure a business’s ability to generate income from its primary source of income. Therefore, return on net operating assets is a more rigorous measure to know if a company is doing well in its industry and sector.
The calculation of return on net operating assets is dividing the net income after taxes for the specific period by net operating assets, or you can check the formula in the image below:
Net Income After Taxes
Net income represents the profit or income generated from the operations of the business. Net income is after-tax income, and it is calculated by subtracting all the operating expenses from the revenues generated from the primary business operations. Once we get the net income before tax, then will have to deduct the income tax. Income tax is pending on tax at the countries operating in.
Net Operating Assets
Net operating assets are calculated by subtracting the operating liabilities from operating assets. Operating assets differ from total assets as it includes only those directly involved in revenue generation.
Cash, cash equivalents, and financial securities are held as an investment and these assets are not the operating assets. Operating liabilities are short-term liabilities that include accounts payable, accrued expenses, deferred taxes, deferred liabilities, etc.
Net operating assets can also be calculated by using a financing approach. The following formula is used for the calculation:
Net Operating Assets = equity + Short-term and Long-Term Non-Operating Debts (Non-Current Operating Assets) – Financial Assets and investments – Excess cash and cash equivalents
Let’s take an example of a company Becken & Co. The company has a net income of $200,000 during the last financial year. The total assets of the company were reported to be $2 million. Out of $2 million, $0.5 million worth of marketable securities sit in the company’s balance sheet. Total liabilities as reported on the balance sheet of the financial year are $1.5 million. The value of financial liabilities in the balance sheet is $0.5 million.
What is the return on net operating assets of Becken & Co.?
We will start with the calculation of operating assets and operating liabilities.
Operating assets= Total assets – Financial assets(marketable securities)
Operating assets = $2 million – $0.5 million
Operating assets = $1.5 million
Operating liabilities = Total liabilities – Financial Liabilities
Operating liabilities = $1.5 million – $0.5 million
Operating liabilities = $1 million
Net operating assets = Operating assets – Operating liabilities
Net operating assets = $1.5 million – $1 million
Net operating assets = $0.5 million
Return On Net Operating Assets = Net Income After Tax/ Net Operating Assets
Return On Net Operating Assets = $130,000/ 500,000
Return On Net Operating Assets = 0.26
Return On Net Operating Assets = 26%
Interpretation And Understanding Return On Net Operating Assets
The calculation of return on net operating assets is just one part of the financial analysis. It is important to understand a ratio and results by interpreting them accurately.
- The first and foremost information you get from a company’s return on net operating assets is its ability to generate profit from its equity and assets. Investors looking for opportunities to invest in companies with better performance in their respective industries can rely on this value to understand its true growth potential.
- The efficiency of resources is also depicted by the return on net operating assets as the main source of the company’s income is its operating profit. From this information, management can assess the utilization potential of their resources and take corrective actions if necessary.
- In ROE and ROEC, there are high chances of the returns being influenced by the company’s financial investments and not the actual business profits. Therefore, the investors can break down the firm’s real profitability and performance efficiency by using the return on net operating assets.
Another question is often asked. What value of return on net operating assets will be considered as good?
There is no ideal value for return on net operating assets. Additionally, a standalone ratio cannot be good or bad to base your whole decision regarding investment or other actions. Therefore, it is necessary to understand that financial ratios only give useful insights when compared correctly.
For instance, you might think that an RNOA of 45% is good enough for a company. But the whole perspective will be changed if you get to know that industry benchmark RNOA is 75%. Therefore, the ratios are never used in isolation.
Even then, if you want to do a standalone analysis based on RNOA, it will provide insights into the operating returns of a company. If the company’s debt ratios change, it will not impact the RNOA, so stakeholders interested in its operational efficiency can rely on the ratio.
How To Improve Return On Net Operating Assets
When the net operating asset return is evaluated, the increasing value represents the business entity’s higher efficiency in utilizing its available resources. Therefore, a higher RNOA is better than the lower one.
But what if a company has lower RNOA than the industry benchmark and other competitors?
Of course, it is time to take corrective measures for improving return on net operating assets.
What can be done to improve RNOA?
- As the return is calculated on the net income, improving operating income is the most significant action to improve the overall RNOA. It includes improving marketing and sales effort to generate higher revenues, increasing market share, retaining existing customers, cutting operating costs by economies of scale, etc.
- A technical strategy to increase your company’s return on net operating assets is to sell off operating assets. However, this strategy is not beneficial as it will be more damaging in the long term. By selling off your assets, you leave your debts uncovered, indicating that the company is not financially stable. Therefore, you should not go with this way of improving RNOA.
There are many advantages of calculating the return on net operating assets for a company. It benefits investors as well as management. Investors can differentiate between investing and operating activities. It also benefits management as the debt ratio or financial leverage does not impact the value of RNOA. Besides, RNOA cannot be manipulated and shows the growth potential of a business with precision.
Some limitations of RNOA include that it cannot be standalone representative of a company’s efficient performance. There are different approaches, capital models, etc.; therefore, precisely calculating operating assets and liabilities is complicated.
In a nutshell, investors and management can use RNOA to understand the dynamics of a company’s performance in comparison with industry benchmarks and other financial metrics of a business entity.