How to Calculate Return on Assets (ROA)
It's useful for investors to learn how to calculate a financial ratio known as return on assets (ROA). ROA is an important measurement because it provides an idea of the underlying nature of a business in a way that differs from return on equity (ROE). Its value varies by sector and industry.
Why Return on Assets Matters
Asset turnover tells an investor total sales per dollar of assets on the balance sheet. ROA lets an investor see how much after-tax profit a company generated for each dollar in assets. In other words, ROA measures a company’s net earnings in relation to all the resources it had at its disposal—the shareholders’ capital plus short- and long-term borrowed funds. Thus, ROA is the most stringent test of return to shareholders. If a company has no debt, the return on assets and return on equity will be the same.
Measure the ROA a company produces over a multi-year period and watch for changes. Occasionally, this shows you something is happening in the business that could be a harbinger of future prosperity or a warning of coming doom.
Two Methods of Calculation
There are two acceptable ways to calculate ROA:
- Method 1: Net profit margin x Asset turnover = Return on assets
- Method 2: Net income ÷ Average assets for the period = Return on assets
Method 1 requires you to calculate net profit margin and asset turnover before you can calculate ROA. In most of your analyses, you will have already calculated these figures by the time you get around to ROA. This example will go through the entire process using Johnson Controls as the sample business.
Using data from Johnson Controls' Form 10-K and annual report (shown in the tables at the bottom), the first step is to calculate the net profit margin. To do this, divide $469,500,000 (the net income) by the total revenue of $18,427,200,000. You'll come up with 0.025 (or 2.5%).
Next, calculate asset turnover. Average the $9,911,500,000 total assets from 2016 and $9,428,000,000 total assets from 2017 together and come up with $9,669,750,000 average assets for the one-year period you are studying. Divide the total revenue of $18,427,200,000 by the average assets of $9,660,750,000. The answer, 1.90, is the total number of asset turns. You now have both components of the equation to calculate return on assets:
.025 (net profit margin) x 1.90 (asset turn) = 0.0475, or 4.75% ROA
Method 2. The second method for calculating ROA is much shorter. Simply take the net income of $469,500,000 divided by the average assets for the period of $9,660,750,000. This is 0.04859, or 4.85%.
$469,500,000 (net income) ÷ $9,660,750,000 (average assets) = 0.04859, or 4.85% ROA
You may wonder why the ROA is different depending on which of the two equations you used. The first, longer option came out to 4.75%, while the second was 4.85%. (The difference is due to the imprecision of the calculation. Specifically, the decimal places were truncated; e.g., you came up with asset turns of 1.90 when in reality, the asset turns were 1.905654231. If you opt to use the first example, it is good practice to carry out the decimal as far as possible.)
The average ROA for the industry Johnson Controls operates in is 1.5%, so the 4.75% ROA for Johnson Controls suggests its management is doing a much better job than its competitors. This should be welcome news to investors.
Asset Intensity as a Business Measure
ROA is also a sure-fire way to gauge the asset intensity of a business. The lower the profit per dollar of assets, the more asset-intensive a business is. The higher the profit per dollar of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has an ROA of 20%, it means the company earned 20 cents for each $1 in assets. As a general rule, anything below 5% is very asset-intensive (and earns less than 5 cents for each $1 in assets) while anything above 20% is asset-light.
Companies such as telecommunication providers, car manufacturers, airlines, and railroads are very asset-intensive because they require big, expensive machinery or equipment to generate a profit. Advertising agencies and software companies, on the other hand, are generally very asset-light.
Think about what happens once a software program has been developed. It is downloaded through websites or app stores. Apart from ongoing updates, each subsequent unit doesn't require a comparable amount of labor. This means the business model is scalable and a single big hit can transform a small software firm into a titan in a short period of time. A widget factory, in contrast, has to do the same amount of work to produce each widget.
|Johnson Controls 2017 Income Statement Excerpt|
|Period Ending||Sep 30, 2017||Sep 30, 2016||Sep 30, 2015|
|Cost of Revenue||$478,300,000||$472,400,000||$419,600,000|
|Preferred Stock and Other Adjustments||($8,800,000)||($9,800,000)||($13,000,000)|
|Net Income Applicable to Common Shares||$469,500,000||$462,600,000||$406,600,000|
|Johnson Controls 2017 Balance Sheet Excerpt|
|Long Term Assets||$4,544,000,000||$4,277,200,000||$4,805,300,000|
|Long Term Investments||$300,500,000||$254,700,000||$254,700,000|
|Property, Plant and Equipment||$2,379,800,000||$2,305,000,000||$1,996,000,000|
|Deferred Long Term Asset Charges||N/A||N/A||N/A|
|Total Stockholders' Equity||$2,985,400,000||$2,576,100,000||$2,270,000,000|
|Net Tangible Assets||$738,100,000||$442,800,000||$173,100,000|