Return On Assets (ROA) Ratio
Return on assets is the ratio of annual net income to average total assets of a business during a financial year. It measures efficiency of the business in using its assets to generate net income. It is a profitability ratio.
The formula to calculate return on assets is:
|ROA =||Annual Net Income|
|Average Total Assets|
Net income is the after tax income. It can be found on income statement. Average total assets are calculated by dividing the sum of total assets at the beginning and at the end of the financial year by 2. Total assets at the beginning and at the end of the year can be obtained from year ending balance sheets of two consecutive financial years.
Return on assets indicates the number of cents earned on each dollar of assets. Thus higher values of return on assets show that business is more profitable. This ratio should be only used to compare companies in the same industry. The reason for this is that companies in some industries are most asset-insensitive i.e. they need expensive plant and equipment to generate income compared to others. Their ROA will naturally be lower than the ROA of companies which are low asset-insensitive. An increasing trend of ROA indicates that the profitability of the company is improving. Conversely, a decreasing trend means that profitability is deteriorating.
Example 1: Total assets of Company X on July 1, 2010 and June 30, 2011 were $2,132,000 and $2,434,000 respectively. During the year ended June 30, 2011 it earned net income of $213,000. Calculate its return on assets ratio.
Average Total Assets = ( $2,132,000 + $2,434,000 ) / 2 = $2,283,000
Return On Assets = $213,000 / $2,283,000 ≈ 0.09 or 9%
Example 2: Total liabilities and total equity of Company Y on Dec 31, 2010 were $942,000 and $1,610,000 respectively. During the year ended Dec 31, 2010 the company earned net income of $315,000. What were the total assets of the company on Jan 1, 2010 given that its ROA for the year was 0.12
Step 1: Average Total Assets = Net Income / ROA = $315,000 / 0.12 = $2,625,000
Step 2: Ending Total Assets = $942,000 + $1,610,000 = $2,552,000
Step 3: Beginning Total Assets = ( 2 × $2,625,000 ) − $2,552,000 = $2,698,000
Written by Irfanullah Jan