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What is return on assets (ROA)?
Return on assets (ROA) is a financial ratio business owners and investors use to understand how much profit a business generates using its assets. It's sometimes referred to as the return on assets ratio.
The purpose of return on assets is to understand the profit a business generates as a percentage of its total assets. If a company generates a higher ROA, that company is considered more efficient at turning its investments into profit. Likewise, a lower ROA is considered less efficient.
Imagine two companies: one with $1 million in assets and another with $100,000 in assets. If both generate $50,000 in profit, the one with fewer assets is considered more efficient at generating profit because it requires less capital to hit that mark.
How do I calculate return on assets?
To calculate return on assets, you need to know two numbers: net income and average assets.
Return on assets is only calculated over a fiscal year of activity; you need at least 12 months of reporting to calculate this financial ratio.
Net income is easily found at the bottom of your income statement. This is the total amount a business pockets after covering its expenses.
Finding your average assets requires looking at your total assets at the start and end of the period. Add these two numbers together and divide by two.
You need to calculate average assets since they change with the purchase or sale of inventory, equipment, land, or vehicles.
Once you have this information, put it into the return on assets formula:
Return On Assets = (Net Income / Average Total Assets) x 100
What’s included in total assets
Your total assets value is found in the top section of your balance sheet.
Included in total assets are both long and short-term assets. Some examples of assets are total cash balance, accounts receivable, inventory, PP&E (property, plant, and equipment), investments, and intangible assets (like intellectual property).
Return on assets examples
Sterling’s Stetsons is an online shop selling hats. After their first year of operations, they want to calculate their ROA to see if they were efficient at generating profits with their assets.
Since their inventory is always changing, they start by calculating their average total assets. They crunch the numbers and find an average total assets value of $200,000. Next, they check their income statement and see they recorded $50,000 in profit for the year.
Using their average total assets and net income values, they calculate their company's ROA by:
Return On Assets = (Net Income / Average Total Assets) x 100
Return On Assets = ($50,000 / $200,000) x 100
Return On Assets = 25%
What does return on assets tell you?
Return on assets is a metric that’s best looked at over time, especially if you’re going to be investing money into the business to purchase new assets.
Say your assets have remained the same but your profit goes up because an influencer unexpectedly plugged your product. Your ROA increases as a result, but what does that really mean? This doesn’t necessarily mean you have become more efficient at using your assets to generate profit.
On the flipside, say you invested money into the business to buy more equipment. As your assets have increased, you’ll want to know how your ROA has been impacted. If your ROA increased or stayed the same, then you know that your business was efficient at turning those new assets into profit.
ROA is especially valuable if you’re looking to bring on investors. If you can show that you’ve used new assets to generate more profit efficiently, you prove that new investment is likely to turn into higher net profit numbers.
What’s a good return on assets value?
There isn’t necessarily a “good” return on assets value. Different industries have different required assets to operate. Even comparing two similar companies like a dropshipping company and an ecommerce company that manufactures their own goods will have different levels of assets.
To best understand whether you have a good ROA number, consider doing the following:
- Compare your ROA with the ROA of similar businesses
- Compare your ROA before and after the acquisition of new assets
Even then, your ROA isn’t a make or break metric. For example, if a company acquires more assets, it might take time to actually put them to use and affect the company's profitability. Maybe it adds new production equipment but they don't have the additional employees to operate it yet.
Instead, focus on using ROA with an intended purpose. Be it benchmarking your business against others or understanding how new investment impacts your operations, that’s when ROA provides the most value.
Understanding return on assets
A company's return on assets isn't something to be understood at a glance. To properly understand the return on assets metric, you need to look at the company's balance sheet and income statement.
As with all financial ratios, there are two factors at play. Return on assets could be high or low because of a company's net income, its total assets, or a combo of both.
To begin with, a company's assets, and how they use them to generate profits, is influenced by many different factors including its industry, goals, and operations.
For example, comparing the return on assets of an asset intensive company like a manufacturer versus an asset light company like a graphic design firm doesn't make sense.
Similarly, comparing the return on assets for a company that's focused on increasing its savings versus a company that's investing in its growth doesn't hold much value.
In these cases, the return on assets reflects more about how the company is composed as opposed to the company's efficiency. Ultimately, it's best to compare the return on assets of companies in the same industry and with similar goals.
