If you’re new to the business, you may have heard the term “Return on Assets” or “ROA” mentioned a few times. In this article, we’ll explore what ROA means, how it’s calculated, and how businesses can improve it to become more profitable.
What Does Return on Assets Mean?
In simple terms, Return on Assets tells us how efficient a business is at generating profit from the assets it owns. Assets are the things that a business owns, such as property, equipment, and inventory. In this context, return means the profit a business generates from these assets.
Return on Assets Definition
ROA is a profitability ratio that’s calculated by dividing net profit by total assets. This ratio is usually expressed as a percentage, so remember to multiply the result by 100. However, there’s a catch: net profit is the financial gain generated over some time, while total assets are the things that a business owns at a single point in time. To compare like with like, we can use average total assets, which is equal to closing total assets plus opening total assets divided by two. This will give us a more accurate picture of a business ROA.
Where to Find Net Profit and Total Assets
Net profit is usually found on the income statement, which summarizes a business’s revenues and expenses over some time. Total assets, on the other hand, are found on the balance sheet, which provides a snapshot of a business’s assets, liabilities, and equity at a single point in time. To calculate ROA, we need to use the figures for closing total assets at the end of the current year and opening total assets, which are the same as last year’s closing total assets.
How to Calculate Return on Assets
Let’s take an example to understand how to calculate ROA. SMD Contractors is a company that designs and builds infrastructure all across the Sunflower Valley. We have their income statement and comparative balance sheet, which we can use to calculate their ROA. ROA is equal to net profit divided by average total assets multiplied by 100. Average total assets are equal to closing total assets plus opening total assets divided by two.
To calculate SMD Contractors’ ROA, we’ll start with net profit, which is $45 million for the year ended 31st December. Closing total assets at the end of the current year were $870 million and at the end of last year, they were $930 million. We can find the average total assets by adding these together and dividing them by two, which gives us $900 million. Dividing SMD Contractors’ net profit of $45 million by their average total assets of $900 million and multiplying by 100 gives us an ROA of 5%.
Why is Return on Assets Important?
ROA is a useful metric for investors as it tells us how efficiently a business uses its assets to generate profit. We can compare the ROA of different businesses in similar industries to see which ones are performing better. For example, if SMD Contractors has an ROA of 5%, but a rival construction company has an ROA of 7%, we can see that the latter is more efficient at generating profit from its assets.
How to Improve Return on Assets
Businesses can improve their ROA by increasing their net profit relative to their total assets. One way to do this is to improve their Net Profit Margin, which is equal to net profit divided by revenue. They can achieve this by raising their sales prices, changing the sales mix to focus on higher-margin products or services, or reducing their overheads to improve their operating efficiency. Another way to increase ROA is by improving the Asset Turnover Ratio, which equals revenue divided by total assets. This means earning more revenue from the assets a business owns. Businesses can achieve this by increasing their sales volume, reducing their inventory levels, or selling off underperforming assets.
Conclusion
In conclusion, Return on assets (ROA) is an important metric for businesses to understand as it tells us how efficiently they use their assets to generate profit. By improving their ROA, businesses can become more profitable and successful.
FAQ’S
ROA stands for Return on Assets, which is a profitability ratio that tells us how efficiently a business is using its assets to generate profit.
ROA is calculated by dividing net profit by total assets. The result is usually expressed as a percentage, so remember to multiply it by 100.
ROA is important because it tells us how efficiently a business is using its assets to generate profit. It’s a useful metric for investors as it allows them to compare the performance of different businesses in similar industries.
A business can improve its ROA by increasing its net profit relative to its total assets. One way to do this is by improving its Net Profit Margin, which is equal to net profit divided by revenue. Another way is by improving its Asset Turnover Ratio, which means earning more revenue from the assets it owns.
Net profit can be found on the income statement, while total assets can be found on the balance sheet. To calculate ROA, you’ll need the figures for closing total assets at the end of the current year and opening total assets, which are the same as last year’s closing total assets.
To compare like with like, we use average total assets, which is equal to closing total assets plus opening total assets divided by two. This gives us a more accurate picture of a business ROA.
ROA is equal to the Net Profit Margin multiplied by the Asset Turnover Ratio. This means that a business can increase its ROA by improving either its Net Profit Margin or its Asset Turnover Ratio.
A business can improve its Net Profit Margin by raising its sales prices, changing the sales mix to focus on higher-margin products or services, or reducing its overheads to improve its operating efficiency.
A business can improve its Asset Turnover Ratio by increasing its sales volume, reducing its inventory levels, or selling off underperforming assets.
No, there are several other metrics that are important for businesses, such as Return on Equity (ROE), Gross Profit Margin, and Operating Profit Margin. Each metric provides a different perspective on a business’s financial performance.