Ratio Analysis: Return on Assets

How well is management using the funds it received from both investors and lenders?

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Oct 30, 2019
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Want to know how much a company has earned on the funds provided by investors and lenders? The answer is found in one simple data point: return on assets, or ROA.

It’s one of a relatively small set of ratios that help us effectively analyze businesses, as described by Axel Tracy in his book, “Ratio Analysis Fundamentals How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet.”

Another of those key ratios is return on equity, which refers to how much a company is earning on funds provided by just investors—no lenders. It’s an important distinction: ROA refers to investors plus lenders, while ROE refers to investors alone.

Tracy put the ROA ratio into perspective:

“Why is so much emphasis placed on the Return on Assets? This is because it is a simple indicator to calculate while giving great insight into the success of management to those who fund, or own, the business but are outside of management. After all, the money shareholders or creditors invest in the business is allocated by management in the purchase on income generating assets.”

Basically, return on assets starts with “pre-tax profit, adds back the interest expense and uses the result in a ratio against the assets of the business.” The formula is:

"Return on Assets = (Income before Tax + Interest Expense) / ((Assets at Start of Period + Assets at End of Period) / 2)"

Data for income before tax and interest expense come from the income statement, while assets at start of period come from the previous balance sheet and assets at end of period are found in the current balance sheet.

Tracy pointed out that the result of the ROA calculation is always a percentage; he used the example of a company earning ROA of 18%, which means that 18 cents of every dollar in assets is available to investors and lenders who funded the business.

GuruFocus members simply visit the Summary page for any stock; in this case, the example is Caterpillar (CAT, Financial):

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Clicking on the ROA name takes them to an extended set of data about the company’s return on assets, including its historical returns, how it compares with peer companies and more.

Like most key measures, ROA changes over time. If it is increasing, there are several possible reasons:

  • Management is reducing expenses while holding relative assets constant.
  • Management is increasing sales or revenue, without adding to assets.
  • Managers are otherwise improving their performance.
  • Assets are being consumed when there is no need to maintain or replenish capital expenditures.

In the event of a falling ROA, the opposite of the actions above are occurring, or:

  • Assets are suddenly increasing, but profitability is not. For example, an oil exploration company usually spends a great deal of money on research and developing its well and production facilities before selling its first barrel of oil.
  • The assets may no longer have the same earnings power as they had in the past. Think of Sears’ (SHLDQ, Financial) declining retail sales while the value of its land and buildings stayed the same or went up.

Tracy wrote, “This once again boils down to management performance. Whether it’s competitive pressure, bad strategy or being unable to counter an economic downturn, the nature of the ratio means that most performance inputs are being incorporated (income before tax from the profit and loss statement and asset levels from the balance sheet) and these are management decisions.”

What are the drawbacks of the return on assets ratio? Tracy listed several. First, like the product margin and gross product margin ratios, comparisons are usually just applicable within one industry. When tech companies such as Twitter (TWTR, Financial) and Facebook (FB, Financial) get started, their biggest expense will be wages and marketing, neither of which involves assets. On the other hand, if a company like BHP Billiton (BHP, Financial) starts up, it must spend millions on fixed assets, including land, buildings, mining equipment and so on.

Second, companies can increase their ROA by selling off or reducing their assets to low levels. Tracy doesn’t include the practice of asset stripping, but it would an extreme example of companies reducing their assets. Asset stripping can produce windfall profits for shareholders, but leave the company less viable than it had been. For example, earlier this year, the bankrupt estate of Sears Holdings Corp. and others filed a lawsuit against former Chairman and CEO Eddie Lampert as well as former board members, alleging they had pillaged the company.

Third, depreciation and amortization can reduce the value of assets over time. For example, a manufacturing company will write down its production facilities by a certain amount each year to account for the wear and tear they have experienced. Management has extensive latitude when it comes to depreciation policy in deciding how and how much to depreciate their assets. As Tracy pointed out, two otherwise identical companies may have different policies: One uses straight-line depreciation while the other uses reducing-balance depreciation. The company that used reducing-balance would show higher ROA in the early years of the life of an asset.

Conclusion

Return on assets, or ROA, is a key ratio for investors and lenders because it shows how much a company is earning on the funds it received from them. Those funds were used to buy assets, and the ROA shows how well management is using them.

It is distinct from return on equity because it includes funding from both investors and lenders.

ROA can go up or down, usually in response to changes in revenues and expenses. Whatever the case, management is responsible for policies that affect return on assets.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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