What Is ROA? (Plus Benefits, Limitations and Steps)

By Indeed Editorial Team

Published 16 May 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Assets are items of value that an organisation uses to generate revenue and earn profits. Some examples of assets include office equipment, cash, raw materials, stock and buildings. If you want to analyse a company's performance concerning its assets, it's important to understand the return on assets (ROA) metric. In this article, we answer the question, "What is ROA?", list its benefits and limitations and explain how to calculate it.

What is ROA?

Knowing the answer to the question, "What is ROA?" can help you determine how well a company is performing. Return on assets is a ratio that tells you how much of a profit an organisation earns from its assets and resources. It's often represented as a percentage. The higher the percentage, the more effective an organisation is at using its resources. A higher number shows that the organisation earns more money using fewer assets. For instance, if an organisation's ROA is 8.5%, this means the organisation earns eight and a half cents per dollar in assets.

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Why is ROA important?

Knowing how to calculate an organisation's ROA is important, as it's a valuable measurement that you can use to determine how efficient the organisation is at using its assets to make a profit. You can begin by comparing an organisation's ROA percentage from one year to another and looking for changes or trends. Doing this can help you determine whether an organisation is likely to have potential issues in the future.

You can also use the organisation's ROA percentage to compare the organisation to similar organisations. It's important, though, to make sure you're comparing numbers for organisations that are in a similar industry and are similar in size. This allows you to compare how well an organisation is performing compared to other organisations.

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Calculating a company's return on assets

There are two different methods you can use to calculate a company ROA. The first method is to divide the net income of a company by its total average assets. The second method is to multiply the net profit margin of a company by its asset turnover rate. Here's an overview of each:

ROA using net income and total assets

To calculate a company's ROA using net income and total assets, consider taking the average of the total assets over a particular period of time. You can use that in the ROA calculation since the total assets of a company tend to fluctuate over time. This can happen, for example, when an organisation buys a new vehicle or experiences fluctuations in sales. Using an organisation's average total assets over a period of time can yield more accurate results.

Here are these steps for calculating a company's return on assets:

1. Determine the net income

Net income refers to the total profits a business has generated after deducting all of its expenditures. These expenditures may include operational costs, such as marketing expenses, depreciation of equipment and cost of goods sold. It may also include expenses such as interest paid on debt and tax payments.

Aside from the revenue that the business has generated through sales, the net income can also include additional income. One example of a company's additional income is the interest earned from investments. You can find the company's net loss and income at the bottom of its income statement.

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2. Determine the average total assets

You can find a summary of a company's total assets on its balance sheet. It shows all the business's assets, including buildings, vehicles, inventory, tools, accounts receivable and cash. To calculate the average total assets over a period of time, add the value of the assets at the beginning of the accounting period to the value at the end, and then divide the result by two.

3. Divide the net income by the average total assets

Once you have determined the net income and the average total assets, you can apply the following formula:

Return on assets = net income / total assets

The result is the ROA ratio of a company over a specific period of time. For example, say you want to calculate the ROA of a company that has a net income of $200,000 at the end of the year. To calculate the average total assets, you can add the total assets of two consecutive years. In year one, the company had $3 million in assets, and it had $4 million in year two, which amounts to $7 million.

If you divide $7 million into two, this gives you an average total assets amount of $3.5 million. To calculate the ROA ratio, you divide $200,000 by $3.5 million, which amounts to 0.057. Lastly, multiply this number by 100, which gives you a percentage of 5.7%.

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ROA using asset turnover and net profit margin

Here are the steps you can take to calculate a business's ROA using its asset turnover and net profit margin:

1. Determine the company's net profit margin

Begin by determining the company's net profit margin. To do this, divide the net income of the company by its total revenue, with the total revenue being the denominator and the net income being the numerator. Then, multiply the result by 100. You also can find this information on the company's annual report. For example, say the company's net income is $200,000 and its total revenue is $2,000,000. If you divide $200,000 by $2,000,000, the result is 0.1. If you multiply that by 100, the company's net profit margin is 10%.

2. Determine the company's asset turnover

The next step is to determine the asset turnover of the company. To do this, you can divide the company's total revenue by its average assets. The total revenue is your numerator and the average assets is your denominator. You also can find this information on the income statement and balance sheet of the company. For example, say the company's average asset is $900,000. If you divide $2,000,000, which is the company's total revenue, by $900,000, the company's asset turnover is 2.222.

3. Multiply net profit margin by asset turnover

Lastly, find the product of the business' asset turnover and profit margin by multiplying the two numbers together. If necessary, you can round the numbers for the business' asset turnover and net profit margin to make the calculation easier. Consider converting the resulting answer to represent the business' ROA in percentage form. Using the example in the previous step, you can multiply the company's net profit margin, which is 10%, by its asset turnover, which is 2.222. The result is 0.2222. If you multiply that by 100, the company's ROA is 22.22%.

The limitations of the ROA metric

The biggest limitation of applying the ROA ratio when comparing companies is that you can't use it across industries. This is because some companies and industries require expensive equipment, properties and plants, such as manufacturers and airlines, while others spend far less on assets to generate income. A service company, for example, has a minimal investment in assets, which results in a very high ROA.

Another reason why it's sometimes challenging to compare the performance of companies based on their ROA ratios is that some companies use a different ROA formula. This involves using their operating income. They don't use their net income as the numerator.

The benefits of the ROA metric

Aside from judging how efficiently a company uses its assets to generate income, company executives and investors can also use ROA ratios to compare different companies within the same industry. If a company has a higher ROA percentage than others, it may serve as an indication that it's outperforming its competitors.

You can also use ROA to determine how asset-intensive a company is. A low ROA percentage of below 5% is an indication of an asset-intensive company. This doesn't necessarily mean that a company is underperforming, though. Certain companies, such as airlines, are naturally more asset-intensive than, for example, software companies, which are asset-light businesses.

What is the difference between the return on assets and the return on equity?

The way that an organisation's debt is taken into account is the primary difference between the return on assets and return on equity. Without debt, investor equity and the organisation's total assets are equal. Logically, its ROA and ROE are also the same.

If that organisation takes on financial leverage, though, its ROE is higher than its ROA. By taking on debt, an organisation increases its assets due to the cash that comes in. If the company's returns are constant, its assets are now higher than its equity. Also, the denominator of the ROA calculation is higher because assets are higher. Thus, ROA falls while ROE stays at its previous level.

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