Return on Assets (ROA): How to Use & Calculate This Key Investment Metric

By Chika

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Last Updated: April 15, 2022

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There are various metrics investors use to carry out fundamental analysis of a company when conducting due diligence. One of the commonly used metrics used by analysts is Return on Assets (ROA).

This is a measure of how efficiently a company uses the assets it owns to generate profits. Managers, analysts and investors use ROA to evaluate a company’s financial health.

Let's find out more about ROA, including how you can calculate it and use it as a yardstick to select stocks for your portfolio. 

4 Benefits & 7 Ways to Conduct Due Diligence in Picking Stocks

 

What is ROA?

Return on assets is a metric that compares the value of a company's assets to the profits it generates over a period of time. Managers and financial analysts use Return on Assets to measure how well a firm is using its resources to create a profit.

If it seems complicated, consider how ROA would operate at a for example, a steel production company.

  • The corporation has a number of production factories as well as the equipment and technology required to produce steel.
  • It also keeps a supply of raw materials on hand, as well as unsold inventories.
  • Then there's the cash and currency equivalents it maintains on hand for company costs.

All these items would constitute the corporation's assets when calculating ROA. 

 

How to Calculate Return on Assets (ROA)

To calculate ROA, simply divide a company’s net profit by its total assets, then multiply the result by 100.

ROA = (Net Profit / Total Assets) x 100

Public companies report net profit on their income statements, and disclose their total assets on their monthly, quarterly, or annual balance sheets. You can find these statements in a company’s quarterly earnings reports.

From our example, let’s say assume the steel manufacturer reported a net profit of $5.5 million in 2020, and total assets at the end of the year of $48.5 million.

To determine the company’s ROA for 2020, you would divide $5,500,000 by $48,500,000 and multiply the result by 100. This gives you an ROA of 11.34%. Based on this calculator, we can conclude that for every dollar in assets owned, the steel company earn 11.34 cents in profit.

 

Advanced ROA Formula

The value of a company's assets fluctuates over time, therefore a more complex ROA calculation takes that into consideration. To account for this, utilize the average worth of the company's assets over the course of a year, rather than the entire value of its assets at year's end.

Divide net profit by average assets and multiply by 100 to find the percentage of a company's assets.

ROA = (Net Profit / Average Assets) x 100

Continuing the example from above, you would average the value of the steel manufacturer’s assets from 2020, discovering that its average asset value is only $33,500,000, lower than the total at the end of the year.

When you divide the company’s net profit of $5,500,000 by $33,500,000, you get a ROA of 6.09%. This ROA is more accurate than the 11.34% figure in the example above.

 

How to Use Return on Assets

The Return on Asset (ROA) is a useful indicator for assessing a particular company's success.

When a company's ROA improves over time, it means it's extracting more profit from each dollar it holds in assets. A falling ROA, on the other hand, indicates that a firm has made poor investments, is overspending, and may be in trouble.

Comparing ROAs among organizations, on the other hand, should be done with caution. The return on asset (ROA) is not an effective metric for comparing enterprises of different sizes or sectors.

Even among firms of the same size in the same sector, expected ROAs might range, since they are at various phases in their corporate lifecycles.

Because of these considerations, ROA is best applied to a single firm across time. Plotting a company's ROA quarter by quarter or year by year might help you figure out how well it's doing.

Rising or dropping Return on Assets might help you see how the firm is changing over time.

 

What is a Good ROA?

A Return on Asset of 5% or more is regarded as good. A ROA of 20% or more is considered outstanding.

In general, the greater the ROA, the more profit-generating efficiency of the firm. However, the ROA of any given firm must be compared to that of its peers in the same industry and sector.

An asset-heavy firm, like a manufacturing, may have a ROA of 6%. An asset-light company, like a dating app, would have a ROA of 15%. If you just compared two apps on the basis of return on investment, you'd probably choose the app.

However, if you compared the manufacturing company to its closest competitors, and they all had ROAs below 4%, you might find that it’s doing far better than its peers.

Conversely, if you looked at the dating app in comparison to similar tech firms, you could discover that most of them have ROAs closer to 20%, meaning it’s actually underperforming more similar companies.

 

ROA vs. ROE

Return on Equity (ROE) and Return on Assets (ROA) are two financial ratios that may be used to assess a single company's performance.

ROE is determined by dividing a firm's net earnings over a certain time by its shareholders' equity. It indicates how well the company is leveraging the capital it has raised via stock sales.

If ROA looks at how well a firm manages its assets to make money, ROE looks at how effectively the company manages the money invested by its shareholders to make money.

The return on equity (ROE) is a metric that investors use to determine the effectiveness of their public business investments.

ROA, which measures a company's asset efficiency, adds to the findings drawn from ROE.

This might come in handy: The 20 Basic Financial Acronyms You Should Know & Understand

 

Limitations of ROA

While ROA is a useful metric, it isn't the only way to assess a company's efficiency and financial health.

A company's ROA is impacted by a variety of other factors. This includes market circumstances and demand, as well as the shifting cost of assets it requires. To gain a complete view of a company's overall financial health, ROA should be combined with other metrics such as ROE.

Photo by Headway on Unsplash

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