The term return on assets (ROA) refers to a financial ratio that indicates how profitable a company is in relation to its total assets. Corporate management, analysts, and investors can use ROA to determine how efficiently a company uses its assets to generate a profit.
The metric is commonly expressed as a percentage by using a company’s net income and its average assets. A higher ROA means a company is more efficient and productive at managing its balance sheet to generate profits, while a lower ROA indicates there is room for improvement.
ROA for public companies can vary substantially and are highly dependent on the industry in which they function, so the ROA for a tech company won’t necessarily correspond to that of a food and beverage company. This is why, when using ROA as a comparative measure, it is best to compare it against a company’s previous ROA numbers or a similar company’s ROA.
The ROA figure gives investors an idea of how effective the company is in converting the money it invests into net income. The higher the ROA number, the better, because the company is able to earn more money with a smaller investment. Put simply, a higher ROA means more asset efficiency.
Equation: Return on Assets = Net Income / Total Assets
Special conditions: Because of the balance sheet accounting equation, note that total assets are also the sum of its total liabilities and shareholder equity. Both types of financing are used to fund a company’s operations. Since a company’s assets are either funded by debt or equity, some analysts and investors disregard the cost of acquiring the asset by adding back interest expense in the formula for ROA. The impact of taking more debt is negated by adding back the cost of borrowing to the net income and using the average assets in a given period as the denominator. Interest expense is added because the net income amount on the income statement excludes interest expense.
Note: ROA shouldn’t be the only determining factor when it comes to making your investment decisions. In fact, it’s just one of the many metrics available to evaluate a company’s profitability.