July 10, 2018
ROA shows how good how profitable a company’s assets are. It gives an idea about the capacity of these assets in generating revenue. It reflects the capital intensity of the company. The number will be different for different industries. But normally the value of 5% is considered to be a decent value.
ROA shows how effectively the company can make use of its assets to get maximum profit. A high ROA shows that the company has a solid performance as far as finance and operation of the company is concerned. A low ROA is not a good sign for the growth of the company. A low ROA indicates that the company is not able to make maximum use of its assets for getting more profits.
If you want to increase the ROA then you must try to increase the profit margin or you must try to make maximum use of the company assets to increase sales. A higher ratio is always better. This is because it indicates that the company is using its assets effectively in order to get more net income. You must make use of ROA to compare companies in the same industry. Avoid using ROA for comparing companies in different industries as the ROA for different industries is different.
Return on assets is equal to the ratio of the net income of the company in a given period to the total value of the company’s assets. It is a financial ratio.
Net income/ total assets = Return on assets
You can also make use of the formula product of profit margin and total asset turnover.
You can get the value of net income from the income statement.
Let us consider the example of a company XYZ. Their net income is found to be Rs 469,500,000 and the value of the total assets is found to be Rs 9,660,750,000. Now when you divide the two you get the value 0.0485. That is 4.85%.
Now if the average ROA of the industry in which the company XYZ is involved is less than 4.85% then we can say that this company is doing well. But if the average ROA of the industry is more than that of the company then the company XYZ needs to be concerned about its performance. They need to take active measures to improve their performance.
Some companies depend heavily on the assets that the company has. Examples of these types of industries are the airline industry, car manufacturers, telecommunication etc. On the other hand software companies do not need heavy assets. Once a software is developed then all that the same can be downloaded from apps etc.
Also, all that the company has to do is invest in a few updates. So even if this company gets one major success then it can give a big boost to the company. On the other hand in the airline industry, the company has to make heavy investments in buying and maintaining assets.
Return on assets and return on equity are examples of determining the company’s capacity to get more profits and get more earnings from their investments. But it must be noted that these are not the same things. Both these entities give an idea about the corporate health. Together they give an idea of the performance of the company. But they have some major differences.
As we have already seen that ROA is the ratio of annual net income and total assets. ROE is the ratio of Annual net income and average shareholders equity.
By taking debts the company increases its assets. When debt increases the equity will decrease and as a result, the ROE value will increase. ROE will not give you a clear idea about how a company is using its finances. ROA helps you understand how well the company uses both forms of finances that is debt and equity. So if you want to get a correct idea about how the company is performing then you have to consider both ROA and ROE.
It is always important that investors know how well the company is doing performance wise. This can be found out by considering the return of asset of the company. The value of return of asset of the company will be different for different industries. If the company’s ROA is more than that of the industry then you can say that the company is effectively using its assets. In order to understand the actual financial position of the company, one must take into consideration both the ROA and the ROE. Both gauge company performance but both are different and both are calculated differently. One needs to scrutinise both these values closely in order to determine the actual standing of the company. Sometimes by considering just ROE can mislead the investor. So he must take into consideration both the ratios.