Calculating Return on Assets (ROA)

Return on assets is a measure of how effectively a company is using the asset base it has to generate a profit. Return on assets (ROA) is measured with the simple formula: net income / total assets. This measure can be confusing to an individual who does not understand how ROA can fluctuate across industries and over time.

Understanding the Formula

In this formula, net income is profit after taxes and expenses. Total assets include both equity and the debts a company has incurred through loaned monies. Even though many people do not think of debt as an asset, for the purposes of this measurement, any active debt that has not gone into delinquency is an asset to the company because it provides capital to be turned into profit.

ROA Example

Some industries are prone to having a high ROA. These industries tend to have a very low barrier to entry. This means they do not need a large amount of equity to operate. Instead, they can begin operations with a relatively small store front, or perhaps even a website. For example, an online magazine does not need a lot of assets to operate. For the $1,000 it put into creating a website, it could generate $10,000 in profits in a given year. In comparison, a physical magazine producer may need to purchase printers, binding equipment, cameras and other assets prior to going into operation. For its initial $10,000 investment, this magazine may generate $50,000. Even though the income of the second magazine is higher, the first magazine has a more favorable ROA. 

Industry ROA Fluctuation

In the above example, an investor may be tempted to invest in the first magazine because of its higher ROA. A month later, that investor may find out another online magazine generated $100,000 of profit from a $2,000 investment. The investor would quickly realize they were comparing apples to oranges when making the decision to invest. The investor should have been comparing online publisher to online publisher. This is a key feature to understand. Comparing like businesses is the only way to truly understand if a company's ROA is acceptable and profitable.

Company ROA Fluctuation

You may see a particular company has a fluctuating ROA from time-to-time. Seasonal businesses are likely to post a highly fluctuating ROA depending on the time of year. For example, imagine a construction company with $10 million in assets. In the winter months, the company cannot operate to capacity, and it only earns $5 million. The return on assets may appear pathetic, perhaps even putting the company at risk of bankruptcy. However, once the company enters the summer months, its income for one quarter is $30 million. The ROA has suddenly changed, showing the true financial strength of the business. In order to understand a company's performance, you must not only compare it to like companies but to like business cycles. Compare Q1 profits from a construction company to Q1 profits from another construction company. Year-by-year, pay attention to seasonal cycles to understand how a company is growing.

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