How to Interpret the Return on Assets Ratio

The return on assets ratio (ROA) for any individual company shows how effectively it has turned its investments into profits. The model uses the simple formula of net income divided by total assets. A company that has a higher ROA has made comparably more profit  for the investment either the owners or individual investors have made. However, the formula must be interpreted knowledgeably in order for one to truly understand the success of the company's management at turning a profit.

Example

To understand ROA, use this example. Sam's Internet company earns $1,000 a year. Sarah's magazine earns $10,000 a year. To most people, investing in Sarah's company would seem like a much better option at first glance. However, a knowledgeable investor asks Sam the total value of his assets, i.e., how much he paid to start his company's operations. Sam's assets total $100; this is the cost he incurred to set up his website. His ROA, then, is 100 percent, which is extremely high. The same investor asks Sarah the total value of her assets. She explains she required $20,000 from investors in order to obtain the equipment to print her magazine. Her ROA is only 50 percent. Therefore, an investor who places $100 in Sam's company will make more in return on that $100 in a single year than an investor who places the $100 in Sarah's company.

Debt to Equity Consideration

One important factor to understand when analyzing ROA is the fact that both equity and debt count as assets in the calculation. In the above example, if Sarah invested $10,000 of her own money and took $10,000 in loans, all $20,000 would count as her assets. However, it is clear to see that she is operating at a very high debt ratio. This could expose her to bankruptcy if a slow sales cycle were to occur. Always consider how much of a company's assets are in debt when looking at this ROA ratio. A company with a slightly lower ROA but far less debt than another company may be a more advantageous and safer investment.

Industry Consideration

Some industries continue to operate with very low ROAs. For example, the automobile industry has an extremely high cost of entry. To begin making cars, a company must invest millions of dollars in equipment and factories, raising its total assets. However, the Internet sales industry is on the exact opposite end of the spectrum. A company like Google or eBay can start up with very little capital investment. Therefore, some industries will permanently operate at higher ROAs than others. This does not mean you should not invest in automobile manufacturers. It does mean, though, that you should compare one manufacturer to another in its own industry if you are considering ROA as a factor in your investment. Within an industry, a company with a higher ROA will be, for the most part, a more profitable company. Using this figure in addition to factoring in debt to equity ratios can give you a clear picture of how well an individual business manages its assets and puts them to work.

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