Return on Assets Ratio

Every company makes investments in assets as part of their adopted business growth strategies. Goods based industries, such as vehicle manufacturers, are very asset intensive as they require huge investments in assets such as machinery, in order to make optimum profits. Service based industries such as advertising agencies are asset light industries as they require very less investments in assets. The Return on Assets (ROA) ratio shows how much profit a business makes for every $1 invested in assets. In short return on assets ratio shows how profitable a company's assets are. It is also referred to as Return on Investment (ROI) ratio. Now that we know what return on assets ratio is, let's learn how to calculate it.

Return on Assets Ratio Calculation
Return on assets ratio is calculated in percentage. It is calculated by dividing a company's net earnings by its average total assets. The mathematical formula for return on assets ratio is:

ROA = Net income / Average total assets

Average total assets are calculated by adding the total assets that a company has, in a given period, and dividing it by two. If a company AB had $1 million in assets in 2008 and has $2 million in assets in 2009, the average asset value for the period would be calculated as $1 million + $2 million = $3 million, divided by 2 = $1.5 million. As far as net income is concerned, some investors add interest expenses to the income while calculating return on assets ratio. In such a case, the formula for calculating ROA ratio becomes:

ROA = (Net income + Interest expenses - interest tax savings) / Average total assets

A high return on assets ratio indicates that the business is earning more money and investing less on assets. Return on assets is an indicator of the asset intensity of a company. Manufacturing firms usually have lower return on asset as they require huge investments in assets compared to the service industries. A low return on asset ratio shows that the company is more asset-intensive. A high percentage of return on assets indicates that the company is less asset-intensive. It also means that lesser investments are needed in assets to make profits. In the industry, as a general rule, return on assets ratio below 5% indicates that the company is asset heavy and return on asset ratio above 20% indicates that the company is asset-light.

Uses of Calculating Return on Assets Ratio
ROA helps to determine a lot of factors as well as aids in taking certain decision related to business and investment. Some of them are listed below.

Assessment of Asset Management
Return on assets gives an idea as to how efficiently the management of a company is utilizing its assets to generate income. Let's take an example to understand this better. Say a company has net income of $2 million and total assets worth $10 million. Its return on asset ratio would be 20%. Now take another example of a company which has the same income i.e. $2 million but its assets are worth $ 20 million. In this case the return on assets ratio would be 10%. The higher return on asset ratio of the first company shows that its management is making right investment decisions as the same amount of profit is being earned and the investment in assets is almost half to that of the second company.

Determination of Investment Decisions
The return on assets ratio percentage is used by the investors to gauge how effectively the company is converting the money it has in debt and equity to invest in net income. A higher return on asset ratio attracts more investors and they readily buy stocks of such companies.

Profit Indication
Return on assets ratio is used to make comparisons between two companies or within two time periods in the same company. A comparison of return on assets figures within the same company will give an idea of whether investment decision amendments incorporated by the company, have been successful in generating more earnings or not. A comparison of return on asset figures of two companies, indicates which company is better at utilizing its assets for generating profits. Return on asset figures should always be compared between companies belonging to the same industry. Return on asset should not be used to compare two unrelated businesses as requirements of asset investments vary from industry to industry.

Determination of Shareholders' Profit
Return on asset ratio is of top priority to the shareholders. A high percentage of return on assets shows that the company's assets, which include the capital invested by share holders, have been utilized in best possible manner to generate high earnings. Return on asset is a means to determine the amount of return earned by the shareholders.

ROA ratio is very easy to calculate. It is also very essential as it's an important part of financial management of a company and helps in financial planning for the future. Business managers, investors and shareholders, all look at the return on asset ratio figures, to ascertain the returns of the investments and thus, adopt a future course of action accordingly.