Return on Assets (ROA) - Meaning,

Formula, Assumptions and Interpretation

Another metric that is widely used by investors to gauge the profitability of a company is
Return on Assets (ROA). More about this very important ratio has been stated in this article.
Formula
Return on Assets = Earnings / Asset Base
Some calculations may include intangible assets while some others may exclude them
from calculation of Return on Assets.
Meaning
he Return on Assets (ROA) ratio shows the relationship between earnings and asset base of the
company. he higher the ratio! the better it is. his is because a higher ratio would indicate that
the company can produce relatively higher earnings in comparison to its asset base i.e. more
capital efficiency.
Assumptions
No Write-dons!
he ROA ratio assumes that the assets have been valued fairly on the boo"s.
#owever! in real life! it is a "nown fact that companies "eep over and$or under
valuing their assets to reduce taxation. his may affect the ROA adversely and
reduce its usability as a profitability metric.
E"#ess $as% and Assets &or 'ale!
he Return on Assets ratio assumes that the company is using all its assets to run
the day to day operations. his assumption is li"ely to be proved incorrect. A lot
of companies hold significant cash on their balance sheet. he most valuable
company in the world Apple %nc is one such example. Also many other companies
hold a lot of impaired and obsolete assets which they plan to sell in the near
future. his brings down the Return On Assets (ROA) ratio.
Interpretation
(oes Not (epend on )e*erage!
Return on assets compares the earnings that a company has generated to its asset
base. he asset base could be financed by e&uity or by debt but it will not ma"e a
difference. Return on Assets is therefore independent of leverage.
'tage o& +rot%!
Return on Assets is very sensitive to the stage of growth that a company is
currently experiencing. %n the introduction and growth stage! companies invest a
lot of money to create asset bases. hey may not use the asset base immediately
and the benefits may be reali'ed years later. #ence! two companies in the same
industry! but at different stages of growth! will have very different Return On
Assets.
2
Return on (&uity (RO() is probably the most important number in the financial universe. E*er,
#ompan, is dri*en -, pro&it and Return on E.uit, (ROE) is #onsidered to -e t%e -est
indi#ator o& t%e pro&ita-ilit, o& a #ompan,. )ebt holders *ust want to get their interest and
principle bac" i.e. they will obtain a fixed rate of return. On the other hand e&uity holders get a
variable return. +or this reason! this number is considered more important than Return on Assets
or Return On %nvested ,apital.
Formula
Return On $apital In*ested = /ro&it A&ter 0a" (/A0) / E.uit,
Return on (&uity (RO() is one of the few ratios that uses after tax profits
Meaning
Return on e&uity tells the shareholders how many dollars of post-tax earnings! the
company generated for every dollar of e&uity capital it had.
Assumptions
No (ilution! he Return on (&uity (RO() figure does not ta"e into account the
outstanding share warrants. his is because there is uncertainty as to whether the
derivate products will be exercised and whether the e&uity base of the company
will change. #owever! if warrants are exercised and e&uity is diluted! the RO(
figure could change drastically.
)e*erage to $ontinue! he return which is being compared against e&uity has
been generated by using debt too. he Return on (&uity (RO() ratio assumes that
the current gearing ratio i.e. leverage of the firm is li"ely to continue in the future.
Moreover Return on (&uity (RO() may go up or down because of a change in
leverage alone. RO( going down could be a good sign too because it would mean
de-ris"ing of the company.
0a"ation to $ontinue! he Return on (&uity (RO() also assumes that the
taxation structure will remain the same in the future. %f comparisons are being
made with past RO(.s then there is an implicit assumption that the tax structure
has not changed.
Interpretation
1aluation Multiple! RO( is the most widely used ratio for valuation of a firm.
(&uity investors are interested in the earnings that the firm will generate for them.
RO( provides a direct measure. herefore investors usually buy shares at
multiples of RO(.
+estation /eriod! RO( may be affected by the gestation period. A company may
borrow money today to invest in long term facilities. he returns may ta"e some
time to start. his will show a low RO( but may be a positive sign. +or this
reason! RO( may not be an accurate measure
3
Return on %nvested ,apital (RO%,) is another popular metric that is used widely in
financial analysis. he reason for its popularity is that li"e ROA! RO%, can be used by
both e&uity and debt holders. Also! li"e ROA! it provides data about return to the
company as a whole and is not affected by leverage. #ere is more about Return on
%nvested ,apital/
Formula
he formula for calculating RO%, is as follows0
Return on In*ested $apital = EBI0 / In*ested $apital
(eri*ing In*ested $apital! 1ote that %nvested ,apital is not the same as ,apital
listed on the balance sheet. 1either is it the balance sheet total. %nvested ,apital is
a term analysts have coined in the recent past to denote capital that has been listed
for the long term in the company.s operations. %nvested capital is derived by
starting from the 2alance Sheet 3iabilities total and then subtracting the current
liabilities from it. his is because current liabilities are not sustainable sources of
long term financing and therefore cannot &ualify as capital.
Meaning
he Return on %nvested ,apital (RO%,) metric measures the company.s efficiency at
allocating its resources to generate the maximum return. hus RO%, shows the
relationship between invested capital and return. %t must be thought about as having Rs 4
in earnings for every rupee in invested capital.
Assumptions
0a" /lanning not $onsidered! he Return on %nvested ,apital (RO%,) used
(2% which is a pre-tax figure. his ratio does not consider that companies can
ma"e significant differences to their profitability with the help of tax planning
strategies. Some analysts use both pre-tax and post-tax RO%, numbers to get a
better picture of the company.s operations.
A##urate Boo2 1alues! he Return on %nvested ,apital (RO%,) assumes that the
boo" values stated are accurate. %n many cases! the boo" values and the mar"et
values of assets are very different. One such example is land. hus! RO%,
becomes a misleading figure. his is because many times analysts consider the
opportunity cost based on mar"et value and the RO%, drops drastically.
Interpretation
No Brea2-3p /ro*ided! RO%, does not provide brea" up about whether income has
been earned from regular operations or from one time activities.
3sed to E*aluate A#.uisitions! Return on %nvested ,apital (RO%,) is useful in case
of companies that have done many ac&uisitions. Since it is difficult to segregate the
cash flows of the two merged companies! RO%, with and without the ac&uisition
serves as a measure of gauging success.