Better Returns using Assets – Importance of ROA
Return on Assets is yet another important profitability ratio that explains the company’s ability to earn profits by utilizing its Assets.
In this example, we will explore about Return on Assets ratio. We will look at Formula, Examples, Interpretation, and detailed margin profile for various companies.
What is Return on Assetss?
Return on Assets or ROA in short, explains the company’s ability to earn profits by utilizing its Assets efficiently.
It tells if the company’s management is making proper use of its Assets or not.
If the ratio is higher, it means the company is utilizing its Assets in a better manner. On the contrary, if the ratio is lower, it means the company is inefficient in managing its assets.
Let us look at the calculation of the ratio.
Formula for Return on Assets
The formula for the Return on Assets is very logical we take net income in the numerator average total assets are taken in the denominator
Well, the definition of Return as part of the formula may have many variations.
Although Net Income is often used in the numerator, other variants like Earnings before Interest and Taxes (EBIT) or Profit after Tax + (1 – Tax rate) may also be used.
Throughout this resource, we consider Net Income (Profit after Tax) as a return measure and we take Net Income in the numerator.
The numerator can be easily obtained from the Income Statement. We reduce all the expenses from the Revenue like Direct expenses, Interest expenses, and even Taxes to arrive at Net income.
If net income includes any one time income, it has to be adjusted to get a clear picture.
Average Total Assets
We take average total assets in the denominator
Average total assets = (Current year-end Total Assets + Previous year-end Total Assets) /2
Although analysts use year-end Total Assets, it is preferred to use Average Total Assets.
We need to consider both tangible and intangible assets as part of this formula. Fictitious assets reported on the Balance Sheet should not be considered since such assets will not generate any profits.
Let us calculate the ratio using an example given below.
How to calculate Return on Assetss – Example
Consider two companies Alpha Inc. and beta Inc..
We assume that both the companies operate in the similar sector Hence, can be used for comparison.
To calculate the Return on Assets for both the companies we are given the below Income Statement.
We are also given the Balance Sheet for both the companies.
To calculate Return on Assetss we need,
- Net Income
- Avg Total Assets
Net Income or Profit after tax can be calculated from the Income Statement.
We reduce all the expenses from Revenue to arrive at PAT.
Alpha Inc. is = $300 – $60 – $30 – $15 – $15 – $54 = $126
Beta Inc. = $400 – $100 – $80 – $20 – $20 – $54 = $126
It is important to note that both the companies have same profit after tax. But their revenue is different.
We add all the assets in the Balance Sheet to arrive at Total Assets.
Total Assets = Fixed Assets + Cash and Cash Equivalent + Receivables + Inventory + Other Assets
Since the company does not have any fictitious assets we are safe.
Alpha Inc. = $20 + $300 + $80 + $310 + $10 = $720
Beta Inc. = $20 + $100 + $40 + $300 + $20 = $48
The numerator and denominator for both the companies are summarized in the chart below.
As given in the bar chart above, Alpha Inc. has more assets relative to Beta Inc.
Now, as we have both the numerator and denominator we can proceed to calculate the ratio.
Return on Assetss = Net Income / Average total assets
Alpha Inc. = $126 / $720 = 17.5%
Beta Inc. = $126 / $480= 26.2%
As evident from the calculation above, Alpha Inc. has ROA of 17.5% and Beta Inc. has 26.2%
So, what does ROA of 17.5% and 26.2% mean?
It means that for every $100 of assets, Alpha Inc. makes Net Income of $17.5.
Similarly for every $100 of assets employed by the beta Inc., it makes $26.2 as Net Income.
Clearly, among both the companies Beta Inc. has higher Return on Assets.
This indicates that Beta Inc. manages its assets more efficiently and earn relatively higher profits for its shareholders.
Of course, ultimate conclusion should not be made solely on this metric.
Return on Assetss using Excel – Walmart Inc case study.
In this case study we will calculate the Return on Assets for US-based retail company Walmart.
We will specifically focus at calculations for the year ended 31st January 2020.
You can download the Excel template using the below option.
Once you download the template you would see the below given consolidated income statement
The file also has the consolidated Balance Sheet for the company
To calculate Return on Assetss we need two values.
- Net Income
- Average total assets
Net income can be calculated from the income statement.
We reduce all the expenses incurred by Walmart know the profit after tax.
Net Income = Revenue – Cost of Sales – S,G & Admin Expenses – Depreciation and Amortization – Interest Expenses – Income taxes
= $523,964 – $394,605 – $97,804 – $10,987 -$452 – $4,915 = $15,201
Hence, Net Income of Walmart is $15,201
Avg Total Assets
Average total asset for Walmart can be calculated from the Balance Sheet.
Average total asset = (Period-end Total Assets + Previous Period-end Total Assets) / 2
= ($236,495 + $219,295)/2 = $227,895
Average total assets for Walmart is $227,895
Since we have both the numerator and denominator we are now in a position to calculate the ratio.
Return on Assetss = Net Income / Average total assets
= ($15,201 / $227,895) * 100 = 6.7%
So, what does Return on Assetss of 6.7% indicate?
ROA of 6.7 % indicate that for every $100 of average total assets deployed into the business, company earns only $6.7 of Net Income
Clearly, the company does not earn a significantly high Return on Assets. This may indicate that the company might be not fully efficient in utilising its assets.
Although the return profile of only 6.1% may appear to be very minimal, this might be an industry-wide phenomenal. And before concluding if it is good or bad one must understand that industry dynamics.
If the industry is capital intensive then it becomes very difficult for the companies to earn significantly higher return.
How to Interpret Return on Assetss?
Higher Return on Assets would mean that the company is very efficient in asset utilization.
If the ROA of the company is continuously increasing, it means that the management is efficiently deploying its assets and generating higher and higher returns.
Lower ROA would mean that the company has burdened itself with too much of assets and it is unable to make the best use of them to generate profits.
ROA can be used to compare the company’s weighted average cost of Capital (WACC).
A Return on Assets that is greater than WACC indicates that company is creating value to its capital providers.
Similarly if the company is unable earn a Return on Assets that is more than WACC, it is destroying value.
Decomposing ROA – DuPont Analysis
An important application of Return on Assetss is in DuPont analysis.
As depicted in the the chart above, Return on Assetss can be decomposed as below
ROA = Net Income / Total Assets
- Net Profit Margin = Net Income / Sales
- Asset Turnover Ratio = Sales / Total Assets
Hence, understanding ROA will also help in analyzing Return on Equity using DuPont Analysis in a better manner.
Return on Assetss Case Study 1: Home Depot
As part of understanding this ratio in-depth, let us look at a case study involving US-based home improvement company Home Depot.
In the chart above we have shown The Net Income, Average Total Assets and Return on Assetss for the past 5 years.
If we recall the formula,
Return on Assetss = Net Income / Avg Total Assets.
ROA of any company will increase if,
- Net Income increases
- Avg Total Assets decrease.
If you observe the chart closely, we can see that over the past few years Average Total Assets have moderately increased relative to Net Income.
Clearly, the Net Income of the company increased at a faster rate than that of Average Total Assets.
Hence, over the past year the ROA is in increasing trend.
In the next few sections let us look at the return profile for companies in various industries. This helps in understanding capital intensity in such industries.
We just saw in the previous case study that Home Depot was able to increase its ROA during the past 5 years.
The company has been successful in strategically limiting its Asset base. Also periodically the company carries out buyback of Equity Shares. As a result of which most of its Cash Balance is given back to the shareholder. This resulted in a reduction of assets.
Hence, the company would earn higher ROA for the existing shareholders.
For the year ending 2015, the ROA of the company was around 17%. Within 5 years the company was able to increase it to 24%, a clear 38% improvement.
We have already seen the return profile of Walmart as part of the example above.
The company makes very low ROA in the range of to 4% to 7%..
As evident from the Consolidated Balance Sheet above, the company has significant Assets on its Balance Sheet. This is hindering growth.
Company should strategically limit its asset base if it wants to increase ROA in the coming period.
For the year ending 2019, Walmart Return on Assets was 7% which was 85% above from its previous year’s ROA.
Compared to Walmart and Home Depot, Amazon relatively has very low ROA.
Company has been earning very low single-digit return on its overall Assets deployed into the business.
Compared to its 1% during 2015, there has been significant improvement over the past few years.
Currently, Amazon earn 6% ROA on its overall business.
Significant Assets on its Balance Sheet would explain such a low return.
Looking at the improvement in the Fixed Asset Turnover ratio, Company is expected to earn an increasing ROA in the coming period.
Unlike other industries, Technology Industry is not capital intensive. So significant assets are not required to make profits. The future of the companies depends upon how well they differentiate among themselves and provide cutting edge solutions leveraging on technology.
Apple is a US based consumer electronics manufacturer and software and online services provider.
The Company does not have significant Fixed Assets on its Balance Sheet. Most of its assets are in the form of cash and cash equivalents and long term Investments.
The company has been earning ROA has been in the range of 13 % to 17% over the past five years.
For the year ended 2019, company made Net Income of $16 on every $100 of assets deployed in the business.
Among all the companies under the discussion, clearly, Facebook has improved its ROA significantly.
Back in 2015, the ratio was moderate at 8%. Immediately, in the next year, the company was able to earn better profits with the same Asset base. As a result of which the ratio more than doubled to 18%.
Due to its inherent business model the company was able to scale up the business with no additional assets to be deployed. Hence, subsequent incremental profits resulted in increased Return on Assets.
For the year ended 2019 Facebook Return on Assets was 16%
Similar to Facebook your Microsoft was able to increase its return profile in the past few years.
Back in 2015, the company earned moderate $7 as Net Income on every $100 of Total Assets.
During 2019, Microsoft had a ROA of 14%.
As evident from the chart above, US automaker Tesla made a phenomenal turnaround in its business.
Property, Plant and Equipment forms a significant part of the company’s Assets base.
Every year the company was suffering losses leading to a negative return on its assets. In 2016, the company was able to significantly reduce its losses. This helped it’s ROA to improve drastically.
During 2019 the ratio increased to -2% which is far better than -13% of 2015.
Whether the company would be able to efficiently use its Assets as it scales up the business is yet to be seen.
Johnson & Johnson
The ROA profile of US-based Pharmaceutical and medical instrument manufacturer Johnson & Johnson looks relatively stable.
Every year, the company comfortably makes a net income of more than $10 on every $100 of Assets.
Compared to 2015, there has been a 2% fall in ROA. Since then, the company is making a steady-state 10% for the past three years.
In the case of US-based Global Payment platform provider PayPal, we can see a gradual increase in its ROA.
The company has Property, Plant and Equipment, Intangibles and Investments as part of its Assets base.
Although, the company is gradually increasing its net income, the asset base is also increasing at similar pace.
Hence, there has been not much improvement in the past two years
For the year ending 2019, on every $100 deployed into assets, the company earned a moderate $5 as Net Income.
The ROA profile for yet another US-based company, ExxonMobil has been quite volatile.
Property, Plant and Equipment forms more than 70% of the company’s overall asset base.
For the past 5 years, company has been earning ROA in the range of 3% to 5% only.
For the year ending 2019, the company had Total Assets worth $362,597 million. With such a huge Balance Sheet size, the company is finding it really difficult to earn higher returns.
In this resource, we understood everything about ROA.
It is important to recall that ROA may differ from company to company based on Capital Intensity and Industry dynamics.
Companies in Aviation, Oil, and Gas, Retail that generally are capital intensive sectors, earn low ROA.
On the other hand, Technology, Franchise businesses are not very capital heavy. Hence, comparing two or more companies from totally different industries based on ROA would lead to wrong results.
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