savio13
Savio Cabral
ROA, on the Way
Sure, it’s interesting to know the size of a company. Each year Fortune Magazine publishes a list of the 500 biggest companies by asset base. But ranking companies by the size of their assets is rather meaningless unless one knows how well those assets are put to work for investors. As the name implies, return on assets (ROA) gauges how efficiently a company can squeeze profit from its assets, regardless of size. A high ROA is a telltale sign of solid financial and operational performance.
Calculating ROA
The simplest way to determine ROA is to take net income reported for a period and divide that by total assets. To get total assets, calculate the average of the beginning and ending asset values for the same time period.
ROA = Net Income/Total Assets
Some analysts take earnings before interest and taxation, and divide over total assets:
ROA = EBIT/Total Assets
This is a pure measure of the efficiency of a company in generating returns from its assets, without being affected by management financing decisions.
Either way, the result is reported as a percentage rate of return. An ROA of, say, 20% means that the company produces Rs.1.00 of profit for every Rs.5.00 it has invested in its assets. You can see that ROA gives a quick indication of whether the business is continuing to earn an increasing profit on each Rupee of investment. Investors expect that good management will strive to increase the ROA--to extract greater profit from every Rupee of assets at its disposal. A falling ROA is a sure sign of trouble around the corner, especially for growth companies. Striving for sales growth often means major upfront investments in assets, including accounts receivables, inventories, production equipment, and facilities. A decline in demand can leave an organization high and dry, and over-invested in assets it cannot sell to pay its bills. The result can be financial disaster.
ROA Hurdles
Expressed as a percentage, ROA identifies the rate of return needed to determine whether investing in a company makes sense. Measured against common hurdle rates like the interest rate on debt and cost of capital, ROA tells investors whether the company’s performance stacks up. Compare ROA to the interest rates companies pay on their debts: if a company is squeezing out less from its investments than what it's paying to finance those investments, that's not a positive sign. By contrast, an ROA that is better than the cost of debt means that the company is pocketing the difference.
Similarly, investors can weigh ROA against the company’s cost of capital to get a sense of realized returns on the company’s growth plans. A company that embarks on expansions or acquisitions that create shareholder value should achieve an ROA that exceeds the costs of capital; otherwise, those projects are likely not worth pursuing. Moreover, it's important that investors ask how a company's ROA compares to those of its competitors and to the industry average.
Sure, it’s interesting to know the size of a company. Each year Fortune Magazine publishes a list of the 500 biggest companies by asset base. But ranking companies by the size of their assets is rather meaningless unless one knows how well those assets are put to work for investors. As the name implies, return on assets (ROA) gauges how efficiently a company can squeeze profit from its assets, regardless of size. A high ROA is a telltale sign of solid financial and operational performance.
Calculating ROA
The simplest way to determine ROA is to take net income reported for a period and divide that by total assets. To get total assets, calculate the average of the beginning and ending asset values for the same time period.
ROA = Net Income/Total Assets
Some analysts take earnings before interest and taxation, and divide over total assets:
ROA = EBIT/Total Assets
This is a pure measure of the efficiency of a company in generating returns from its assets, without being affected by management financing decisions.
Either way, the result is reported as a percentage rate of return. An ROA of, say, 20% means that the company produces Rs.1.00 of profit for every Rs.5.00 it has invested in its assets. You can see that ROA gives a quick indication of whether the business is continuing to earn an increasing profit on each Rupee of investment. Investors expect that good management will strive to increase the ROA--to extract greater profit from every Rupee of assets at its disposal. A falling ROA is a sure sign of trouble around the corner, especially for growth companies. Striving for sales growth often means major upfront investments in assets, including accounts receivables, inventories, production equipment, and facilities. A decline in demand can leave an organization high and dry, and over-invested in assets it cannot sell to pay its bills. The result can be financial disaster.
ROA Hurdles
Expressed as a percentage, ROA identifies the rate of return needed to determine whether investing in a company makes sense. Measured against common hurdle rates like the interest rate on debt and cost of capital, ROA tells investors whether the company’s performance stacks up. Compare ROA to the interest rates companies pay on their debts: if a company is squeezing out less from its investments than what it's paying to finance those investments, that's not a positive sign. By contrast, an ROA that is better than the cost of debt means that the company is pocketing the difference.
Similarly, investors can weigh ROA against the company’s cost of capital to get a sense of realized returns on the company’s growth plans. A company that embarks on expansions or acquisitions that create shareholder value should achieve an ROA that exceeds the costs of capital; otherwise, those projects are likely not worth pursuing. Moreover, it's important that investors ask how a company's ROA compares to those of its competitors and to the industry average.