Return on Assets (ROA) is a financial metric that measures the profitability of a company in relation to its total assets.
A high ROA means that a company's assets generate high profits, while a low ROA is interpreted as the company's assets not generating excessive profits.
This metric is calculated by dividing the net profit of a company by its total assets. The result is expressed as a percentage.
For example, a ROA of 20% means that for every 100 euros of asset, the net profit of the company is 20 euros. Thus, a high ROA will always be better, as the company will need fewer assets to achieve a certain level of profits.
In addition, with a higher ROA, for the same level of profit, as the assets required will be lower, the investment that will have to be carried out to maintain them will be lower.
Return on Asset formula
The formula for calculating ROA is as follows:
In the numerator we have the net profit which is the gain that the company obtains after deducting all expenses, including depreciation, interest and taxes. This data is collected in the income statement.
Likewise, in the denominator we place the total assets of the company, which are all the goods or rights it owns, and from which a return is expected in the future.
Why is ROA important?
ROA is a relevant metric, as it allows investors and financial analysts to compare the efficiency in generating profits of a company in relation to its assets. A higher ROA indicates that the company is managing its assets more efficiently to generate profits.
It is crucial to keep in mind that ROA is not a perfect measure and has some limitations. For example, it does not take into account the company's cost of capital or its debt structure, which can give a distorted picture of its profitability.
In addition, ROA can vary significantly from one period to another, so it is recommended to analyse it in the context of a longer period. On the other hand, it should be noted that ROA, like other profitability ratios, should be compared with that obtained by companies in the same sector.
How is Return on Asset (ROA) compared to other financial metrics?
ROA can be compared to other financial metrics such as Return on Equity (ROE), which measures a company's performance in relation to its net worth, or Return on Investment (ROI), which measures the return on an investment.
When comparing ROA to these other metrics, it is important to keep in mind that each has a different focus and can provide valuable information about a firm's performance.
For example, ROE can be useful for comparing a company's performance to that of its peers in the same sector, while ROI can be used to determine whether investing in a project or company is profitable, contrasting the net return against the cost of the investment.
It should be noted that, unlike ROA, ROE has in its denominator the company's net worth and not the total assets.
In any case, it is essential to analyse all these metrics together to have a complete view of a company's performance.
When comparing ROA to the cost of capital, it can be determined whether the company is generating enough profitability to cover the cost of obtaining financing.
If the ROA is higher than the cost of capital, then the company is generating an adequate return and could be considered an attractive investment. If the ROA is lower than the cost of capital, then the company is not generating enough return and could be considered a less attractive investment.
The capital structure can also affect the ROA of a company in various ways. For example, if a company uses a high proportion of debt in its capital structure, it can have a higher ROA due to the tax-deductible interest that can be obtained with the debt. However, it can also increase the financial risk of the company if it is not well managed.
Does ROA serve to compare companies from different sectors?
ROA, in theory, can be used to compare companies from different sectors. However, this is not the most recommended because the sector does influence the result. For example, a financial firm and a mining company have very different capital demands and expected profits.
The most advisable is to compare the ROA with that of other companies in the same sector. But, in addition, the cycle that the company is going through must be taken into consideration, whether it is just starting to grow or already in a period of consolidation.
In addition, it must be taken into account that the ROA of a company can be influenced by various factors, such as its capital structure, the efficiency in the management of assets and the quality of investments, so it should not be used as the only measure of comparison.
To make a more precise comparison, it is important to consider various factors that can affect the business results, such as the profitability of the sector in which it operates, the size of the firm, the financial risk, among others.
Another comparison that will have to be made is with respect to the ROA obtained by the same company in previous periods. In this way, it will be possible to know how this indicator has been evolving.
Finally, it is relevant to analyse the market and the organization itself, since the ROA can vary significantly over time due to changes in economic conditions and in the company itself.
How can a company improve its ROA?
There are several ways in which a company can improve its ROA:
- Increase sales: This can be achieved by implementing effective marketing strategies to attract more customers.
- Reduce costs: This can be achieved by reducing unnecessary expenses and improving efficiency in production and resource use.
- Improve efficiency: This includes the implementation of effective management systems and the adoption of quality management practices.
- Invest in assets: Investment in productive assets, such as machinery, technology or intellectual property, can help improve ROA by generating higher revenues or reducing long-term costs.
Limitations of ROA
The main limitation of ROA is that it does not take into account the level of leverage of the company. This, in contrast to ROE which includes in the denominator only the equity.
We can see it as follows: In ROA we are comparing the return of investors (net profit), against assets that are financed both by investors and creditors through debt.
In that sense, to correct this inconsistency, the following alternative formulas can be used:
In the formulas, t is the tax rate, while the EBIT is the operating result.
Example of ROA calculation
Let's assume we have the following data (all in euros):
- Liabilities: 10,000
- Equity: 15,000
- EBIT: 8,000
- Interest: 500
- Taxes: 1,875
To calculate the assets, remember that these are equal to the liabilities plus the equity:
- Assets: 15,000+10,000= 25,000
For the net income, we subtract the EBIT from the interests and taxes:
- Net income: EBIT- interests – taxes= 8,000-500-1,875= 5,625
- The ROA would be: 5,625/25,000= 0.225
The interpretation of the result is that for every 100 euros invested in assets, the company earns a net profit of 22.5 euros.
👉 Find out more about metrics and ratios in our complete fundamental analysis guide.
FAQs about Return of Assets (ROA)
What is a good ROA?
A good ROA is dependent on the company you choose, the timeframe of calculation, and several other factors that make the company a competitive one. There is no exact benchmark value for a good ROA value.
What is ROA in finance?
Return of assets in finance is a monetary ratio that shows how much profit a company generates without factoring it liabilities and creditors.
What does ROA tell?
A rising ROA implies that the company is generating more profit against it assets, while a declining ROA means lower profits against total assets. Companies with lower ROAs may be struggling financially due to poor investment decision or poor funding.