What is Return on Assets?
The return on assets compares the net earnings of a business to its total assets. It provides an estimate of the efficiency of management in using assets to create a profit, and so is considered a key tool for evaluating management performance. It can be an indicator of a superior business strategy, where management is avoiding the use of assets in its operations. For example, a firm that outsources much of its production will have an unusually high return on assets, since it does not have to invest in expensive production equipment.
How is the Return on Assets Used by Investors?
The return on assets figure can be used to compare the efficiency of asset usage within an industry, since each of these businesses should require roughly the same proportions of assets to sales in order to provide goods and services to customers. However, the asset base of a business could vary substantially across industries, so the measure should not be used to compare entities located in different industries. For example, the return on assets of an asset-intensive production facility would not be comparable to the return on assets of an asset-light consulting business.
Calculation of the Return on Assets
Follow these steps to calculate the return on assets:
Divide the net profits by the total assets figure to arrive at the return on assets. The formula is:
Net profits ÷ Total assets = Return on assets
Example of the Return on Assets
ABC International earns $100,000 in its most recent year of operations. As of its year-end balance sheet, the company had $1,000,000 of total assets. This results in a return on assets of 10%, which is derived as follows:
$100,000 Net profits ÷ $1,000,000 Total assets = 10% Return on assets
Limitations of the Return on Assets
When using the return on assets measurement, be aware of the following issues:
Periods covered. A business may be seasonal, so that its profit figures vary wildly by month. To avoid this issue, run the calculation on an annual or trailing 12 months basis.
Asset averaging. The total assets figure in the denominator is as of a single point in time. The asset total on that date could be quite different from the usual asset balance, perhaps due to a major asset acquisition or disposal. Consequently, consider replacing it with an average asset figure that is based on multiple months of balance sheets.
Impact of debt. Part of the financial structure of an entity may be a certain amount of debt. In order to determine the underlying return on assets without the negative effects of interest expense, subtract this expense from the net profit figure in the numerator.
Trend analysis. The results of this calculation should be plotted on a trend line. Doing so reveals any spikes or declines in the measurement that could be precursors of longer-term changes.
Manipulation. The net profit figure is subject to manipulation by management. They could hold off on certain discretionary expenses in order to improve profits. They could also outsource asset-intensive functions (such as production) in order to reduce the total investment in assets.
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