How to Calculate Return on Assets (ROA)
When it comes to investing, it is important to learn how to calculate a financial ratio known as return on assets (ROA). As you continue to improve your investing skills and become a more experienced analyst, you'll find that ROA is an important measurement because it gives you an idea about the underlying nature of the business or enterprise you are studying in a way that is different from return on equity (ROE). This is especially true for certain sectors and industries, and not always in the way you might think.
What Is Return on Assets and Why Is It Important for Investors to Understand?
Whereas asset turnover tells an investor the total sales for each $1 of assets on the balance sheet, ROA tells an investor how much after-tax profit a company generated for each $1 in assets. In other words, ROA measures a company’s net earnings in relation to all of the resources it had at its disposal—the shareholders’ capital plus short and long-term borrowed funds. Thus, return on assets is the most stringent test of return to shareholders.
If a company has no debt, the return on assets and return on equity figures will be the same.
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
Example Calculations Using Both Methods
Method 1. As described above, Method 1 requires that you calculate net profit margin and asset turnover first 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. For illustrative purposes, this example will go through the entire process using Johnson Controls as the sample business.
This example uses the data from 2001's Johnson Controls Form 10-K and annual report, shown below. Measuring the ROA a company produces over a multiyear period and watch for changes. From time to time, this can let you know something is happening in the business that could be a harbinger of future prosperity or a Cassandra warning of coming doom.
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 percent).
You now need to calculate asset turnover. You average the $9,911,500,000 total assets from 2001 and $9,428,000,000 total assets from 2000 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 of the components of the equation to calculate return on assets:
.025 (net profit margin) x 1.90 (asset turn) = 0.0475, or 4.75 percent return on assets
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. You should come out with 0.04859, or 4.85 percent. 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 percent, while the second was 4.85 percent. 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.
Is a 4.75 percent ROA good for Johnson Controls? A little research shows that the average ROA for Johnson’s industry is 1.5 percent. It appears Johnson’s management is doing a much better job than its competitors. This should be welcome news to investors.
Is ROA an Accurate Measure of How "Good" a Business Is?
The return on assets figure 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 percent, it means that the company earned $0.20 for each $1 in assets.
As a general rule, anything below 5 percent is very asset-intensive while anything above 20 percent is asset-light.
Companies such as telecommunication providers, car manufacturers, airlines, and railroads are very asset-intensive, meaning they require big, expensive machinery or equipment in order 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.
That is, the business model is scalable. A widget factory, in contrast, has to do the same amount of work to produce each widget. The result is that a single major hit can transform a relatively small software firm into a titan in a short period of time.
|Johnson Controls2017 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 Controls2017 Balance Sheet Excerpt|
|Long Term Assets|
|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|