Definition of Return on Total Assets
The term “return on total assets” or ROA refers to the financial ratio that assesses the ability of a company to effectively use its available assets to generate earnings. To put it simply, this metric is used to measure the ability of a company to convert its investment in assets into profits. The basic premise for the metric is that it focuses on operating profit rather than on the net income in order to overcome the influences of financing differences and corporate taxation.
Formula
The formula for ROA can be derived by diving the operating profit or earnings before interest and taxes (EBIT) by the average total assets, which is then expressed in terms of percentage. Mathematically, it is represented as,
The operating profit (EBIT) is usually available as a separate line item in the income statement, otherwise, it can be derived by adding back interest expense and taxes to the net income. The average total assets are the average of the value of total assets at the beginning and at the end of the year.
Examples of Return on Total Assets (With Excel Template)
Let’s take an example to understand the calculation of the Return on Total Assets in a better manner.
Example #1
Let us take the example of a company in order to demonstrate the computation of ROA. The company booked a net income of $30 million, while it incurred interest expense and paid taxes of $2 million and $9 million respectively during 2018. The total assets of the company stood at $100 million at the start of the year and ended the year at $120 million. Calculate the ROA of the company for 2018 based on the given information.
Solution:
Operating Income is calculated using the formula given below
EBIT = Net Income + Interest Expense + Taxes Paid
- EBIT = $30 million + $2 million + $9 million
- EBIT = $41 million
Average Total Assets is calculated using the formula given below
Average Total Assets = (Total Assets at the Start of 2018 + Total Assets at the End of 2018) / 2
- Average Total Assets = ($100 million + $120 million) / 2
- Average Total Assets = $110 million
Return on Total Assets is calculated using the formula given below
ROA = EBIT / Average Total Assets
- ROA = $41 million / $110 million
- ROA = 37.27%
Therefore, the company’s ROA for the year 2018 stood at 37.27%.
Example #2
Let us take the example of Apple Inc.’s annual report for the year 2018 to illustrate the concept of ROA. During the period, it generated an operating income of $70.90 billion, while its total assets at the start and end of the year were $375.32 million and $365.73 billion respectively. Calculate ROA of Apple Inc. for 2018 based on the given information.
Solution:
Average Total Assets is calculated using the formula given below
Average Total Assets = (Total Assets at the Start of 2018 + Total Assets at the End of 2018) / 2
- Average Total Assets = ($375.32 billion + $365.73 billion) / 2
- Average Total Assets = $370.53 million
Return on Total Assets is calculated using the formula given below
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ROA = EBIT / Average Total Assets
- ROA = $70.90 billion / $370.53 million
- ROA = 19.14%
Therefore, Apple Inc.’s ROA for the year 2018 was 19.14%.
Source Link: Apple Inc. Balance Sheet
Advantages of Return on Total Assets
Some of the major advantages of return on total assets are:
- As the metric uses operating income, it effectively captures the influence of both equity and debt financing on asset purchases and its ability to generate profit. So, companies with different capital structures can be compared without any adjustment.
- It helps in assessing the capability of the company’s management in utilizing the available assets.
Limitations of Return on Total Assets
Some of the major limitations of return on total assets are:
- This financial metric is not very useful for companies that belong to capital intensive industries or service-based companies. Capital intensive industries need to invest a significant portion of the profit in regular Capex requirements resulting in low value, while service companies have a minimal investment in assets that result in a very high ROA.
- There is a lack of clarity regarding the numerator used in the ratio. Some companies use operating income, while there are others that use net income. As such, peer comparison among companies with different approaches can be misleading.
Conclusion
So, it can be concluded that ROA is an effective financial performance metric that can be used by investors to determine the company’s asset utilization and its management capability. However, there are shortcomings of the metric due to a lack of applicability to certain industries and confusion regarding its numerator. So, this metric can be used but with a pinch of salt to avoid misleading results.
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