Return on assets is one of the most crucial matrices to assess profitability and business operations performance. If the business efficiently manages its operations and utilizes assets, the return on assets is expected to be higher and vice versa.
Detailed understanding
Return on assets is calculated by dividing net income by the total assets. The concept is that assets in the business balance sheet are financed via equity/liability. The business has to pay a certain cost to finance the balance in the debt and equity accounts.
As we understand that the business needs to control the cost to generate higher profit. So, it’s logical to maintain a lower asset base and earn higher profits. Although a higher amount of the assets is considered a good sign from a stability point of view, ROA is about the efficiency of the business to use the assets and generate the return.
The formula to calculate the ROA is given as follows.
Return on assets = Net profit/Total assets of the company
It’s important to note that formula uses net profit, which is calculated after deducting all the expenses from the revenue earned by the business. So, one option to enhance ROI is an increase in the net profit.
Increase in the net profit
The net profit can be increased by increasing the revenue and controlling the expenses. It includes all the expenses, including sales, administrative expenses, marketing expenses, finance expenses, taxation expenses, etc.
The cost of sales can be controlled by the efficient purchase of the material/services used in manufacturing the products. Controlling production wastage, avoiding idle time, and increasing process efficiency can lead to control in the cost of sales.
On the other hand, the administrative expenses can be controlled by only incurring genuine business expenses and ensuring thee needs before approving any expenses.
Likewise, the finance expenses can be controlled by the better financial management of the financing structure to raise the finance. For instance, debt financing is considered a better source of finance than equity financing due to tax deductions on the payment of the interest. On the other hand, the payment for the dividend does not qualify for the deduction on taxes.
Control of the assets
The second option is to decrease the number of assets. However, the business should only consider decreasing/sale the assets that do not add value in the process of a return generation. For instance, the business should try its best to sell the held for sales assets as it seems to deteriorate the asset return.
Further, excessive cash balance can also lead to impairment in ROA. So, the business must find opportunities to invest and get a ROA.
It’s important to note that the business should prefer to enhance the efficiency of the assets, and the second logical option is to sell the asset if better efficiency is not the option.
It’s equally important to note that classification of the assets as current/non-current does not impact the value of return on assets; the formula uses total assets that do not consider if the asset is current/non-current.
Steps to calculate the return on assets – ROA
1. Obtain net profit of the business
The net profit of the business can be obtained by reviewing the profit and statement of the business. The net profit/loss is given at the bottom of the statement.
2. Obtain total assets of the business
Total assets of the business can be obtained by reviewing the balance sheet of the business. The total assets include current assets and non-current assets.
3. Divided net profit with the total business assets
The net profit of the business is divided by the total assets. If the output of the division is greater, the business is considered to be efficient. On the other hand, if the ROA is smaller value, the business is considered less efficient in using the assets.
Example of calculating return on assets
Following values have been extracted from the financial statement of XYZ limited.
Net profit of the business = $20,000
Total assets of the business = $60,000
The given figures can be used in the calculation of the return on assets of the business.
Formula
Return on assets = net profit / total assets
Return on assets = $20,000/$60,000
Return on assets = 33.34%
The business has generated 33.45% on the total assets, which means the business has efficiently used the assets to generate the return.
3 Ways to increase the return on assets
1. Increase the net income of the business
Net income can be increased by enhancing the net profit; this can be done by increasing sales, controlling expenses, managing finance, and better tax planning. This can also be done by increasing overall business efficiency and leading to efficient business operations.
2. Decrease total assets of the business
The business needs to identify the assets that lead to an overall decrease in inefficiency. For instance, excess cash in the current bank account leads to the generation of no return and reduces overall assets efficiency. However, the classification of the assets from non-current to current and vice versa does not impact the total assets.
3. Enhance the efficiency of the assets
Increasing efficiency of the assets leads to higher profit and higher ROA. For instance, starting the night shift can lead to more production, more sales, and more profit. Similarly, investing excess cash in return generating assets can further help in the higher efficiency of assets.
The efficiency can be reviewed for both current and non-current assets of the business. Further, it’s important to note that ROA and asset turnover are linked in nature. If the business has a higher asset turnover, it’s expected to have a higher ROA and vice versa. However, it must efficiently control expenses.
ROA VS. ROE
ROA compares the total return with the assets of the business. It helps to understand if the business has used its assets efficiently in the performance of the operations. On the other hand, the ROE compares the return generated by the business with the total equity.
It’s important to note that finance raised via equity may have been used to purchase assets. Further, the loss of the business may need to be adjusted against equity. Likewise, profit earned by the business is added to the equity under the head of retained earnings.
You may notice that sometimes there can be accumulated loss under the equity section of the balance sheet, and this loss reduces the total equity and led to an increase in the return on equity.
Conclusion
Return on assets helps to understand if the business has efficiently used assets and produced a return. A higher value of the ROA indicates that the business is efficient and able to generate a return. On the other side, the lower value of the ROA indicates that the business needs to improve the efficiency of its operations. For instance, they can start production at night shift; this will increase production and increase the business’s profitability.
The business ROA can be enhanced by controlling expenses and increasing revenue. The expenses to be controlled include sales, administrative expenses, marketing expenses, finance, expenses, and tax expenses, etc.
Another option can be selling the lower performing assets and investing proceeds in the higher return generating assets. The purpose of calculating the ROA is to trace the business efficiency of using the assets and leading to a higher return.
Further, return on equity is different from ROA. ROE uses the equity in place of assets and helps to better understand the efficiency.
Frequently asked questions
Why do analysts calculate return on assets?
Analysts want to understand if the business management can utilize the assets and generate a return on assets. If the business can utilize the assets efficiently, it’s considered to be efficient and vice versa.
How do companies control the return on assets?
The companies can control the return on assets by increasing the efficiency of the operations. For instance, starting night shift for the production can lead to mode production, more profit, and better profitability.
How is the return on assets different from the return on equity?
Return on assets uses total assets in the calculation. On the other hand, return on equity uses the equity in the formula. The analysis helps to understand if the business has been efficient in the generation of return.
What range of the return on assets is considered to be good?
5% ROA is considered to be a good return on assets. However, the greater value of the return on assets is better for the business.
How is investment decision affected by return on an asset?
Better return on assets is considered to be good and indicates efficient business operations. On the other hand, the lower value of the return on assets indicates space to improve the efficiency of the asset.
