RETURN ON ASSETS (ROA)



Return on assets (ROA) is a financial ratio that shows the percentage of profit that a company earns in relation to its overall resources. It is commonly defined as net income (or pretax profit) / total assets. ROA is known as a profitability or productivity ratio, because it provides information about management's performance in using the assets of the small business to generate income. ROA and other financial ratios can provide small business owners and managers with a valuable tool to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. ROA is also used by bankers, investors, and business analysts to assess a company's use of resources and financial strength.

As James O. Gill noted in his book Financial Basics of Small Business Success, most entrepreneurs decide to start their own businesses in order to earn a better return on their money than would be available through a bank or other low-risk investments. If the ROA and other profitability ratios demonstrate that this is not occurring—particularly once a small business has moved beyond the start-up phase—then the entrepreneur should consider selling the business and reinvesting his or her money elsewhere.

It is important to note, however, that many factors can influence ROA, including a firm's degree of capitalization. "ROA favors highly capitalized institutions," Steven Davidson noted in an article for America's Community Banker. "Especially for such institutions, the ROA measure treats equity capital as 'free funds'—there is no 'cost' associated with them. Financial theory as well as common sense tells us that this is certainly not the case." As a result of this and other limitations, it is advisable to combine ROA with other measures of profitability and performance.

USES FOR ROA

Unlike other profitability ratios, such as return on equity (ROE), ROA measurements include all of a business's assets—including those which arise out of liabilities to creditors as well as those which arise out of contributions by investors. For this reason, ROA is usually of less interest to shareholders than some other financial ratios. However, the inclusion of liabilities makes ROA even more valuable as an internal measurement tool, particularly in evaluating the performance of different departments or divisions of companies.

"ROA is a good internal management ratio because it measures profit against all of the assets a division uses to make those earnings. Hence, it is a way to evaluate the division's profitability and effectiveness. It's also more appropriate here because division managers seldom get involved in raising money or in deciding the mix between debt and equity," James A. Kristy and Susan Z. Diamond wrote in their book Finance without Fear. "One of the cardinal rules in managing business professionals is to hold them accountable for only those activities they control. ROA comes close to doing just that."

Another common internal use for ROA involves evaluating the benefits of investing in a new system versus expanding a current system. The best choice will ideally increase productivity and income as well as reduce asset costs, resulting in an improved ROA ratio. For example, say that a small manufacturing company with a current sales volume of $50,000, average assets of $30,000, and a net profit of $6,000 (giving it an ROA of $6,000 / $30,000 or 20 percent) must decide whether to improve its current inventory management system or install a new one. Expanding the current system would allow an increase in sales volume to $65,000 and in net profit to $7,800, but would also increase average assets to $39,000. Even though sales would increase, the ROA of this option would be the same—20 percent. On the other hand, installing a new system would increase sales to $70,000 and net profit to $12,250. Because the new system would allow the company to manage its inventory more efficiently, the average assets would increase only to $35,000. As a result, the ROA for this option would increase to 35 percent, meaning that the company should choose to install the new system.

FURTHER READING:

Allred, James K. "Looking at the Return on Assets." Modern Materials Handling. May 1997.

Bernstein, Leopold A., and John J. Wild. Analysis of Financial Statements. New York: McGraw-Hill, 2000.

Casteuble, Tracy. "Using Financial Ratios to Assess Performance." Association Management. July 1997.

Davidson, Steven. "Measuring Profitability." America's Community Banker. October 1997.

Gill, James O. Financial Basics of Small Business Success. Menlo Park, CA: Crisp Publications, 1994.

Kremer, Chuck, and Ronald J. Rizzuto. The One-Page Financial Statement: How to Make Your Cash Flow, Profit, and Return on Assets Work Together. International Thompson Publishing, 1999.

Kristy, James E., and Susan Z. Diamond. Finance without Fear. New York: American Management Association, 1984.

Larkin, Howard. "How to Read a Financial Statement." American Medical News. March 11, 1996.



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