Few statistical measures are talked about more than return of assets.
Return on assets helps investors figure out how much profit a company is producing relative to its assets. In a sense, you can think of ROA as an indicator of how efficient a company is at producing profits. A company might be producing big profits, but if its ROA is low, it suggests that the company is not producing those profits very efficiently. For investors looking for a good deal, efficiency is very important.
Return on Total Assets – Indicator for Efficiency at Profit-Making
Investors will also use the very closely related indicator called return on total assets to measure the company’s efficiency at producing profits. This ROTA is measured by using the company’s earnings before tax and interest payments (EBIT). ROTA numbers often look better than ROA numbers because contractual obligations have not yet been paid. Make sure you don’t get these two confused.
Return on Assets – The Easy Formula to Remember
The return on assets formula is a very easy one to remember and use. In no time at all you will be able learn how to calculate return on assets and come up with your own ROA numbers by using the formula for returns on assets, though most of the time the numbers will already be calculated for you. In order to calculate ROA you simply have to take a company’s net earnings and divide it by its total assets. This will give you a percentage number that is the ROA. Using the above simple formula you can easily calculate return on assets.
So why is ROA so important for investors? Fact is, once a company has a lot of money, it’s not terribly difficult to make more money. Producing revenues and slim profit margins is a reasonably attainable goal for most already established companies. What is difficult, however, is producing those profits efficiently.
Computing for ROA in this Example
Let’s say you have two national retailers, FloorMart and Bullseye. Let’s assume that FloorMart is America’s biggest retailer and has assets worth $1 trillion dollars, and a net income of $50 billion dollars. Now let’s say Bullseye is a smaller retailer, with assets worth only $500 billion dollars, and produces a net income of $35 billion dollars.
(We’re going to give you some homework. Take the numbers above and calculate the ROA. It’s simple, just divide the net income by the assets and boom, there you go. If you really need help, you can find a return on assets calculator.)
If you just looked at net income, FloorMart would clearly be the better investment. The retailer pulls in $50 billion dollars a year in net income, compared to Bullseye’s $35 billion. Bulleye’s, however, is much more efficient. Bullseye has only half the assets that FloorMart does, but produces much more than half of its net income. This means Bullseye is making better use of its assets, at least when it comes to net income.
Now, you can’t make investment choices based solely on one indicator. However, when just considering the numbers above, Bullseye appears to be the better company, and thus would probably be a better investment, at least if you had to make the investment based solely on ROA. Again, you can’t make investment choices based on just one indicator. You need to identify lots of other factors, like share prices, P/E ratios, future projects, management qualities, etc.
ROA and the Right Context
Return on asset is a very limited indicator. Certainly, it is useful, and it can tell you a lot about how a company is doing at the moment, but without context the number is pretty much meaningless. Let’s go back to the FloorMart scenario above. Perhaps FloorMart had just recently completed a massive expansion, adding 1000 new stores across the United States in the course of the year. Many of these stores may not even be open, but actually still in the construction stage. Regardless, the stores will almost certainly end up counted on the company’s books as assets, but since they are not producing net income, they will make the ROA numbers look weaker.
As you’ve probably already figured out, analyzing stocks is hard work. If investing was easy, we’d all be billionaires (of course, if we were all worth billions, money probably wouldn’t mean much). Indicators, such as return on asset, are very important, but they don’t tell you everything. You will have to craft your own strategy that utilizes these indicators and gives you some key market insights.