GEB Chapter 4
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A) Leverage B) Activity C) Profitability D) Growth E) Liquidity Answer: C) Profitability
Average ratios can vary significantly from one industry to another. For example, manufacturers usually have more assets, as they rely more extensively on their facilities, machinery, and so on, to generate profits. In contrast, companies in the technology sector have fewer tangible assets and more intangible ones such as intellectual property, the value of which is hard to evaluate. Companies in the technology or services fields will often have higher return on assets ratios than manufacturers. This doesn’t necessarily mean that they are performing better financially. That’s why we should avoid comparing ratios between companies operating in different industries. Why calculate the return on assets ratio?It can be good to calculate this ratio when considering whether to invest in a company. “The ratio indicates if the management team is able to generate profits with the assets at its disposal,” says Dimitri Joël Nana. But more importantly, entrepreneurs may want to calculate this ratio to evaluate their own firm’s performance. How to analyze the return on assets ratio?By examining their own company’s return on assets ratio, entrepreneurs can better understand their financial performance. Two types of analysis can be performed: 1. Time analysisThis analysis examines the return on assets ratio’s evolution over time. “This shows how the ratio has trended historically over the past five or ten years. We can then determine if the company has improved its ability to generate profits for a given level of assets,” says Nana. 2. Competitive analysisThe competitive analysis compares the ratio with that of other similar companies. As noted above, comparisons should generally be limited to companies within the same industry. “We can then evaluate to what extent the financial performance is better, similar or lower than that of competitors. If the ratio is 5% while the competitors’ average ratio is 10%, it would be wise to determine why performance is lacking,” explained Dimitri Joël Nana. Four indicators to better understand the return on assets ratioCalculating these four related indicators can also help better understand the return on assets ratio. “These indicators are obtained by extracting various components of the return on assets ratio,” says Nana. They are usually calculated using an analytical method called the DuPont method. The four indicators are: 1. The taxation impactThe impact of taxation is calculated by dividing earnings after tax by earnings before tax. 2. The interest impactThe impact of interest is calculated by dividing earnings before tax by earnings before interest and tax. 3. The EBIT marginThe EBIT margin is equal to earnings before interest and tax (EBIT) divided by total revenue. 4. Asset turnover ratioThe asset turnover ratio is calculated by dividing total revenue by total assets. Calculating these ratios can be important, because they help determine the causes of your company’s over- or under-performance. “If you’re aware that your return on total assets is very low, and you calculate those ratios, you may find that it’s because you’re paying too much interest, for example, or your gross margin is too low,” says Nana. Adding interest back into the calculation?The return on total assets ratio is calculated by dividing earnings after tax by total assets. However, earnings after tax by definition excludes interest. Some analysts add interest back into the numerator, noting that the interest will ultimately go to the creditors (whose debt is included in total assets in the denominator). “This method is not always used. The decision is up to the analyst,” says Nana. Monitoring your business performanceLearn how to use financial ratios to set key performance indicators by downloading our free guide for entrepreneurs.
The term return on assets (ROA) refers to a financial ratio that indicates how profitable a company is in relation to its total assets. Corporate management, analysts, and investors can use ROA to determine how efficiently a company uses its assets to generate a profit. The metric is commonly expressed as a percentage by using a company's net income and its average assets. A higher ROA means a company is more efficient and productive at managing its balance sheet to generate profits while a lower ROA indicates there is room for improvement.
Businesses are about efficiency. Comparing profits to revenue is a useful operational metric, but comparing them to the resources a company used to earn them displays the feasibility of that company's existence. Return on assets is the simplest of such corporate bang-for-the-buck measures. It tells you what earnings are generated from invested capital or assets. ROA for public companies can vary substantially and are highly dependent on the industry in which they function so the ROA for a tech company won't necessarily correspond to that of a food and beverage company. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or a similar company's ROA. The ROA figure gives investors an idea of how effective the company is in converting the money it invests into net income. The higher the ROA number, the better, because the company is able to earn more money with a smaller investment. Put simply, a higher ROA means more asset efficiency. ROA is calculated by dividing a company’s net income by its total assets. As a formula, it's expressed as: R e t u r n o n A s s e t s = N e t I n c o m e T o t a l A s s e t s Return\ on\ Assets = \frac{Net\ Income}{Total\ Assets} Return on Assets=Total AssetsNet Income For example, pretend Sam and Milan both start hot dog stands. Sam spends $1,500 on a bare-bones metal cart, while Milan spends $15,000 on a zombie apocalypse-themed unit, complete with costume.
Let's assume that those were the only assets each firm deployed. If over some given period, Sam earned $150 and Milan earned $1,200, Milan would have the more valuable business but Sam would have the more efficient one. Using the above formula, we see Sam’s simplified ROA is $150 / $1,500 = 10%, while Milan's simplified ROA is $1,200/$15,000 = 8%. Because of the balance sheet accounting equation, note that total assets are also the sum of its total liabilities and shareholder equity. Both types of financing are used to fund a company's operations. Since a company's assets are either funded by debt or equity, some analysts and investors disregard the cost of acquiring the asset by adding back interest expense in the formula for ROA.
In other words, the impact of taking more debt is negated by adding back the cost of borrowing to the net income and using the average assets in a given period as the denominator. Interest expense is added because the net income amount on the income statement excludes interest expense.
ROA shouldn't be the only determining factor when it comes to making your investment decisions. In fact, it's just one of the many metrics available to evaluate a company's profitability. Both ROA and return on equity (ROE) measure how well a company utilizes its resources. But one of the key differences between the two is how they each treat a company's debt. ROA factors in how leveraged a company is or how much debt it carries. After all, its total assets include any capital it borrows to run its operations. On the other hand, ROE only measures the return on a company’s equity, which leaves out its liabilities. Thus, ROA accounts for a company’s debt and ROE does not. The more leverage and debt a company takes on, the higher ROE will be relative to ROA. Thus, as a company takes on more debt, its ROE would be higher than its ROA. Assuming returns are constant, assets are now higher than equity and the denominator of the return on assets calculation is higher because assets are higher. This means that a company's ROA falls while its ROE stays at its previous level. As noted above, one of the biggest issues with ROA is that it can't be used across industries. That’s because companies in one industry have different asset bases than those in another. So the asset bases of companies within the oil and gas industry aren't the same as those in the retail industry. Some analysts also feel that the basic ROA formula is limited in its applications, being most suitable for banks. Bank balance sheets better represent the real value of their assets and liabilities because they’re carried at market value via mark-to-market accounting (or at least an estimate of market value) versus historical cost. Both interest expense and interest income are already factored into the equation. For non-financial companies, debt and equity capital are strictly segregated, as are the returns to each:
So the common ROA formula jumbles things up by comparing returns to equity investors (net income) with assets funded by both debt and equity investors (total assets). Two variations on this ROA formula fix this numerator-denominator inconsistency by putting interest expense (net of taxes) back into the numerator. So the formulas would be:
The St. Louis Federal Reserve provided data on U.S. bank ROAs, which generally hovered under 1.4% between 1984 and 2020 when it was discontinued. Remember that ROA is most useful for comparing companies in the same industry, as different industries use assets differently. For example, the ROA for service-oriented firms, such as banks, will be significantly higher than the ROA for capital-intensive companies, such as construction or utility companies. Let's evaluate the ROA for three companies in the retail industry:
The data in the table is for the trailing 12 months (TTM) as of Feb. 13, 2019.
Every dollar that Macy's invested in assets generated 8.3 cents of net income. Macy's was better at converting its investment into profits, compared with Kohl’s and Dillard’s. One of management's most important jobs is to make wise choices in allocating its resources, and it appears Macy’s management, in the reported period, was more adept than its two peers.
Investors can use ROA to find stock opportunities because the ROA shows how efficient a company is at using its assets to generate profits. A ROA that rises over time indicates the company is doing well at increasing its profits with each investment dollar it spends. A falling ROA indicates the company might have over-invested in assets that have failed to produce revenue growth, a sign the company may be in some trouble. ROA can also be used to make apples-to-apples comparisons across companies in the same sector or industry.
ROA is calculated by dividing a firm's net income by the average of its total assets. It is then expressed as a percentage. Net profit can be found at the bottom of a company's income statement, and assets are found on its balance sheet. Average total assets are used in calculating ROA because a company's asset total can vary over time due to the purchase or sale of vehicles, land, equipment, inventory changes, or seasonal sales fluctuations. As a result, calculating the average total assets for the period in question is more accurate than the total assets for one period.
A ROA of over 5% is generally considered good and over 20% excellent. However, ROAs should always be compared amongst firms in the same sector. For instance, a software maker has far fewer assets on the balance sheet than a car maker. As a result, the software company's assets will be understated and its ROA may get a questionable boost. |
What category of ratios includes return on total assets and return on stockholders equity?
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