ROA and ROE Give Clear Picture Of Corporate Health
Return on equity indicates if a company’s value is growing at an acceptable rate. It’s calculated as annual net income divided by average shareholders’ equity.Say Ed’s Carpets’ net income is $3.822 billion. That same year, stockholder equity is $25.268 billion, and was $6.814 billion the previous year. To get the ROE, average the shareholders’ equity, which would be $16.041 billion, and divide that number into the company’s net income.Ed’s Carpets generates a 23% profit on every dollar shareholders invest. Since many investors are looking for at least a 15% ROE, Ed’s is doing well.Return on assets reveals how much profit a company earns for every dollar of assets. It’s calculated as annual net income divided by total assets.Ed’s has $448.507 billion worth of assets. Its ROA is 0.85% — a low number. Few money managers will consider stocks with an ROA below 5%.The big factor that separates ROE and ROA is debt. By taking on debt, a company increases its assets by the cash that comes in. But since equity equals assets minus total debt, a company decreases its equity by increasing debt. In other words, when debt increases, equity shrinks, and ROE gets a boost. And when a company takes on debt, total assets and ROA increase. This is why BOTH numbers must be considered when evaluating a company’s performance. Debt amplifies ROE in relation to ROA.In Ed’s case, a large amount of debt kept its assets high while reducing shareholders’ equity.If ROA is sound and debt levels are reasonable, a strong ROE shows managers are doing a good job of generating returns.
Reviewed by David KindnessFact checked by Suzanne KvilhaugReviewed by David KindnessFact checked by Suzanne Kvilhaug
What Is Return on Assets (ROA)?
Return on assets (ROA) is a profitability ratio that shows how much profit a company is generating from its assets. As such, it is seen as an indicator of how efficiently a company’s management is deploying the economic resources it has available. ROA is expressed as a percentage and, in general, the higher the number, the better.
Key Takeaways
- Return on assets is a profitability ratio that shows how much profit a company generates from its assets.
- Return on assets (ROA) measures how effective a company’s management is in generating profit from the total assets on its balance sheet.
- ROA is shown as a percentage, and in general, the higher the number, the better.
- Companies with a low ROA usually have more assets involved in generating profit, while companies with a high ROA have fewer assets.
- ROA is most useful when comparing similar companies in the same industry.
Calculating Return on Assets (ROA)
ROA is usually based on a company’s average total assets, which is calculated by adding its total assets at the end of the year (or other period) to its total assets at the end of the previous year (or other period) and dividing by two.
Average total assets is considered a more accurate measure than simply using the total assets at the end of the latest period. That’s because a company’s assets can vary over time due to the purchase or sale of vehicles, land, or equipment, as well as inventory changes or seasonal sales fluctuations. A company’s total assets can be found on its balance sheet.
So the formula for ROA is:
Return on Assets=Total AssetsNet Income
Note that some simplified computations for ROA will use the total assets for a single current period rather than average total assets, as in our examples. In the banking industry, where using average total assets is the standard, it is often referred to as return on average assets (ROAA).
Example of Return on Assets (ROA)
Below is the balance sheet from ExxonMobil‘s 2023 10-K statement showing its total assets for both 2023 and 2022. Since its 2023 total assets were $376.317 billion and its 2022 total assets were $369.067 billion, its average total assets would be $372.692 billion.
And here is the income statement for 2023 for ExxonMobil from the same 10-K, showing its net income for the year of $36.010 billion:
Putting the two numbers together, ExxonMobil’s ROA was 9.7% ($36.010 billion divided by $372.692 billion). By itself, that number doesn’t tell the whole story. Because different industries can have very different ROAs, a more meaningful analysis would be to compare ExxonMobil’s ROA to that of other major oil companies, such as Chevron and BP.
A “normal” ROA will vary to a large extent based on the industry that a company operates in. So be careful when comparing the ROAs of companies in different industries.
What Return on Assets (ROA) Means to Investors
Calculating the ROA of a company can be helpful in tracking its profitability over multiple quarters and years as well as in comparing it against similar companies. However, no one financial ratio should be used to determine a company’s financial performance or potential value as an investment. Other common profitability measures that investors can use include return on equity (ROE) and return on invested capital (ROIC).
Interpreting ROAs
When analyzing a company’s ROA, it’s worth bearing in mind that:
- Companies with a low ROA will usually have more assets involved in generating their profits. For example, a railroad or manufacturing company is likely to require a large capital investment in fixed assets.
- Companies with a high ROA usually need fewer assets to generate their profits—for example, a consulting firm or other service business.
As a result, companies with a low ROA tend to have more debt since they need to finance the cost of their assets. Having more debt is not bad as long as management uses it effectively to generate earnings.
A rising ROA tends to indicate that a company is increasing its profits with each dollar that’s invested in the company’s total assets. A declining ROA may indicate that a company made some poor capital investment decisions and is not generating enough profit to justify the cost of those assets. A declining ROA could also indicate that the company’s profits are shrinking due to declining sales or revenue.
For that reason it can often be useful to compare a company’s ROA over multiple accounting periods. One year of a lower ROA may not be a concern if the company’s management team is investing in its future and the company anticipates increased profits over the coming years.
Comparing ROAs
As mentioned, before making any judgments about whether a particular ROA is good or bad, it’s important to compare companies of similar size and in the same industry.
For example, an auto manufacturer with huge facilities and specialized equipment might have an ROA of 4%. On the other hand, a software company that generates the same profit but with far fewer assets might have an ROA of 18%.
At first glance, the car maker’s ROA might appear low as opposed to the software company’s. However, if the automobile industry’s average ROA is 2%, then the auto company’s 4% ROA is outperforming its competitors, signifying that it is making effective use of its resources. And the software company’s 18% ROA will seem far less impressive if its peers in that industry are averaging, say, 20%.
What Is ROA in Finance?
Return on assets (ROA) is a financial ratio that shows how much profit a company generates from its total assets.
What Are Total Assets?
The total assets on a company’s balance sheet consist of both current assets and long-term assets. Current assets, which are more liquid, can include cash and cash equivalents, accounts receivable, and inventory. Long-term assets will include fixed, tangible assets such as buildings and equipment, and, in some cases, intangible assets such as intellectual property.
How Do You Calculate Return on Assets?
Although there are multiple formulas, return on assets (ROA) is usually calculated by dividing a company’s net income by its average total assets. Average total assets can be calculated by adding the prior period’s ending total assets to the current period’s ending total assets and dividing the result by two.
What Is a Good Return on Assets Ratio?
In general, an ROA of 5% or less might be considered low, and an ROA over 20%, high. However, it’s best to compare the ROAs of similar companies in the same industry. For an asset-intensive company, an ROA of 5% or even 1% might be acceptable.
What Does ROA Tell You?
A rising ROA indicates that a company is generating more profit from its assets. A declining ROA indicates the opposite. But there can also be other factors involved, so it’s helpful to look back over multiple years. A dip in ROA for a single year may be nothing to worry about, but a consistent downward trend calls for a good explanation.
The Bottom Line
Return on assets (ROA) is an important metric for gauging the profitability of a company. It represents a company’s net income as a percentage of total assets. However, it is not the only relevant metric, and investors should make sure to look at the full picture when they compare different companies.
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