Return on assets (ROA) is an indicator of a company's profitability relative to its total assets. ROA gives shareholders, managers and financiers an idea of the effectiveness of a company's management by measuring the percentage of profit it earns compared to the value of its assets.
ROA is calculated by dividing a company's net income by the value of its total assets and multiplying the result by 100:
ROA = (Net income / Asset value) x 100
For example, suppose a car manufacturer made a net profit of €3.5 million in 2021 and your company has €50 million in total assets by the end of that year's fiscal year.
To determine the return on assets we will have to carry out the following operation:
3.500.000 / 50.000.000 = 0,07
0,07 x 100 = 7
Therefore, the company in question has an ROA of 7%, or in other words, for every euro it has in assets, the company is making a profit of 7 cents.
However, the value of company assets changes over time. To calculate ROA more realistically, the total value of assets at the end of the year can be replaced in the equation by the average value of the company's assets over the course of the year. Thus we obtain that:
ROA = (Net income / Average asset value) x 100
ROA measures the capacity of business assets to generate added value, i.e. profit, and is information that is usually studied by a company's stakeholders to decide whether to invest (in the case of shareholders) or finance.
If the ROA is higher than the interest rates established in the market, it means that the company's assets yield above market rates, so it will generate higher profits and it will be interesting to invest in it or finance it.
Normally, an ROA greater than 5% is considered to be good and from 20% onwards it is considered to be very good. However, to know the real profitability of a company, its ROA must be compared with that of other comparable companies in the same sector, since depending on the sector of activity, different volumes of assets are required and different types of ROA are expected.
For example, a company dedicated to software development will probably have considerably fewer assets in its portfolio than a company in the real estate sector (although more human capital in developers does not constitute an asset item on the balance sheet).
Along with ROA, another of the most commonly used ratios to assess a company's profitability is ROE (return on equity), which, instead of the company's total assets, takes into account the company's equity, i.e. the company's resources owned by the shareholders, in addition to the profit or loss for the year.
The ROE is an interesting tool for investors who are thinking of acquiring shares of a company, since its ROE will allow them to determine whether the value of the shares is adequate and therefore its competitiveness in the market. The formula for calculating ROE is as follows:
ROE = total net income/ shareholders' equity
Shareholders' equity is calculated as the difference between the value of all assets and all liabilities, information that can be consulted in the company's balance sheet.
For a company that is not indebted, ROA and ROE will be equal. On the other hand, if it is, ROE will be higher than ROA because of the "leverage effect" of debt, which will provide more liquidity and resources to the company at a lower cost than equity to develop its activity.