Problems with Return on Assets (ROA)

The return on assets is a valuation multiple that investors commonly use in order to evaluate potential investments. Return on assets is calculated by taking the net income of a company, over a particular time period, and then dividing that number by the assets of the company. The purpose of this ratio is to determine how efficiently a company is working with the assets that they have. Even though this ratio can be beneficial at times, there are a few problems associated with it.

Return on Assets

The number that you come up with when calculating return on assets can be compared to other companies in the industry. The hope is that investors will be able to identify companies that are doing well with the amount of assets that they have. If they are being responsible with the assets that they have, investors hope that by investing more money in them, they will become even more profitable in the future.

Intangible Assets

One of the big problems with return on assets is that it does not take into consideration intangible assets. Many companies in today's market rely heavily on intangible assets to provide a great deal of value to the company. These intangible assets can be patents on products, ideas in the heads of employees and strategic relationships with other companies. Many times, companies can hold a great deal of intangible assets and this will not be accounted for in return on assets. If it is accounted for in assets, it may not have the proper value assigned to it. You might end up valuing a company much too low, and making a poor investment decision.

Difficult Comparisons

When using return on assets, you will need data to use as comparison. One of the problems is that many companies in the market today do not have a company that can accurately be compared to them. For example, technology companies might be involved in areas of technology that have not been released to the public yet. These companies might have holdings in many different industries and areas. This means that when you compare this company's return on assets to another company's, you might get a picture that does not tell you much. In order for this ratio to help you, you actually have to find a company that is a good point of comparison. Otherwise, you are getting information that does not apply and therefore does not help you in your investment decisions.

Borrowed Capital

Another potential problem with using return on assets is that it does not take into consideration borrowed capital. The success of a large company will often depend on a combination of debt and equity financing. If you are using this metric to make your investment decisions, you are essentially ignoring the importance of borrowed capital in the success of a company.

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