The Return on Assets ratio explained.

The Return on Assets (ROA) is a “profitability ratio” used to measure how much profit it can generate from its assets. It shows how efficient a company is at earning profits from utilising its economic resources or assets on the balance sheet.

The assets ratio is a great way to look at the value and growth metrics of a business. A rising and consistent return on assets means a business is earning more profit relative to its assets. A declining return on assets may reflect poor capital allocation and potential financial concerns.

The assets of a business include all the resources that help it produce value and profits, including fixed and intangible assets. Like our Return on Capital and Return on Equity ratios, a higher and rising return is always a positive indicator when researching an individual company.

The ratio can be used to compare companies in the same industry. Different industries have different asset returns so a like for like comparison is better. Capital intensive industries require a high value of fixed assets to perform operations which can result in a lower return on asset as the larger asset base can affect the formula, especially mixed with low income.

The opposite is also true, technology and lower capital intensive industries can show a higher return on assets where they have fewer assets required to generate profits.

What is the Return on Assets formula?

• ROA = Net Income ÷ Total Assets. (Net Profit)
• Net Income = Found on the Income Statement and is revenues minus expenses, interest, and taxes.
• Total Assets = Found on the Balance Sheet and is the sum of all short-term, long-term, and other assets.

Some analysts and investors use Average Total Assets due to asset turnover. Taking the average total assets is simply (Current Total Assets) + (Total Assets for previous year) and then divide it by 2.

How to use the ROA ratio?

It is best to use the ratio comparing like for like companies, because not all industries have the same operating requirements and use assets differently. If we compared a scaling SaaS technology business with a ROA of say 25% with a hotel owner operator that has a ROA of 10%, we would assume the SaaS business is a better investment.

However, what if the hotel owner operator’s business has a 10% ROA against its competitors that have an average of 5%? Then we may have found a business doing something better. The opposite may also be the case that the SaaS business may not be so great if the industry average is say 30% ROA.

Let’s work out two examples, the first example reflects 3 companies in the same industry (hotel operators) to compare how each have performed.

	Company A	Company B	Company C
Net Income	$2.53 billion	$2.5 billion	$750 million
Total Assets	$18.0 billion	$27.5 billion	$8.5 billion
ROA	14.05%	9.09%	8.8%

In this case we have 3 companies all in the hotel operating business with substantial asset holdings. If the industry benchmark is 8% then company B and C are doing reasonably well and not reflective of underperformance. However, company A is showing a higher asset return against competitors and the benchmark.

In simple terms it is using its assets more efficiently to drive profits. We can dig deeper into what this business is doing differently to warrant a clear outperformance. It is earning more money with a smaller investment.

Now let us take Company A and do some further research to firstly see if it is showing a higher ROA as an isolated year or is there something else driving this growth. We would pull out the financial statements and go back over a few years to give us a better look.

Company A	2020	2021	2022	2023
Net Income	$1.5 billion	$1.95 billion	$2.28 billion	$2.53 billion
Total Assets	$13.6 billion	$15.8 billion	$17.2 billion	$18.0 billion
	11.02%	12.34%	13.25%	14.05%

So, if we break down past years and dissect our net income and total assets, we can see a rising and growing ROA over time which is a very good indicator of efficiency and not an isolated event. It indicates the company is increasing its profits with each invested dollar.

If Company A has a declining ROA over the same period it can indicate the business might have purchased too many assets or may be failing to use assets efficiently to generate meaningful profits.

For companies that carry no debt (all equity), the shareholders equity and its total assets will be equivalent (and ROA and ROE would be equal).

In Summary…

Whilst these are very simple examples it shows the concept at play either on an individual company level or a comparison against competitors in the same industry.

A company’s asset returns are influenced by a wide range of factors, from market cycles and demand to assets fluctuating in value. A cyclical business that grows earnings from asset dependency will be affected in downtrodden years.

Using the return on assets ratio alongside other ratios and valuation metrics is key. None of these should be used in isolation.

When I spot a high, sustained, and growing ROA it typically warrants a further look at the company. There is no right number, the higher the better goes with out saying. Some say 5% is a good place to start and 20% returns on assets are fantastic, however it all comes down to comparing like for like.

I like the using the return on assets ratio alongside the Return on Invested Capital ratio as it is a clean way to look at both income statement performance and the assets required to run a business.