Return on Assets

11 Key excerpts on "Return on Assets"

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  eBook - ePub

  Financial Literacy

  • Richard A. Lambert(Author)
  • 2016(Publication Date)
  • Wharton Digital Press

    (Publisher)

  Profits are an important indicator of success, but we also need to consider how much was invested to generate those profits. For example, profits of a million dollars are not so impressive if the firm invested a trillion dollars to earn them. Shareholders expect managers to use their resources efficiently. If the firm is not generating an acceptable rate of return on the resources made available to them, then they need to redeploy them to some other use. If the firm has no better uses, then they should return the resources to shareholders (via dividends or stock repurchases) and let the shareholders invest them elsewhere.

  There are many versions of return on investment (ROI) performance measures, but we’ll start with one of the most important: Return on Assets (ROA). As its name implies, ROA is intended to reflect how effectively we used our assets. In the second half of the chapter, we’ll analyze the effects of how we financed the assets, then combine the two factors to show how they jointly impact the firm’s return on equity (ROE). As its name indicates, ROE measures how well the firm did for its shareholders relative to their investment. Operating performance (how well you used your assets) and financing performance (how effectively you financed your assets) both impact shareholders’ return. It’s vital to be able to measure each one separately so we can assess how well we’re doing on each one.

  We measure ROA using the formula:

  The denominator is Total Assets. Recall from the Balance Sheet Equation that Assets = Liabilities + Owners’ Equity, so Total Assets represents the resources contributed to the firm by both investors and creditors. Therefore, the denominator of the ratio does not depend on how the assets were financed, just on the total amount acquired. The numerator in the formula tries to do a similar thing: it represents the profits of the firm before it’s divvied up between creditors (who get the interest expense) and the shareholders (who get the rest). We can’t simply use Net Income in our formula because interest expense has already been subtracted out in its calculation. So all we’re doing is adding it back.17

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  Accounting

  Reporting, Analysis and Decision Making

  • Shirley Carlon, Rosina McAlpine, Chrisann Lee, Lorena Mitrione, Ngaire Kirk, Lily Wong(Authors)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  Return on Assets An overall measure of profitability is the Return on Assets (ROA). This ratio is calculated by dividing profit by average assets. (Average assets are commonly calculated by adding the beginning and ending values of assets and dividing by 2.) Profit refers to profit after income tax unless stated otherwise. The Return on Assets indicates the amount of profit generated by each dollar invested in assets. Thus, the higher the Return on Assets, the more profitable the entity. Selected figures from the 2022 statement of profit or loss for Artistry Furniture are presented in figure 1.24. The 2022 and 2021 Return on Assets of Original Furnishings and Artistry Furniture Limited (entities operating in the same industry) are presented in figure 1.25. FIGURE 1.25 Return on Assets Return on Assets = Proft Average total assets ($’000) 2022 2021 Original Furnishings $35 900 ($287 370 + $233 280)∕2 = 0.138:1 or 13.8% $38 875 ($233 280 + $255 050)∕2 = 0.159:1 or 15.9% Artistry Furniture $16 600 ($65 250 + $51 840)∕2 ∗ = 0.284:1 or 28.4% $9 450 ($51 840 + $41 472)∕2 ∗ = 0.203:1 or 20.3% *Amounts used to calculate average assets are taken from the statement of financial position (see figure 1.27). Total assets in 2020 were $41 472 000. Also note that amounts in the ratio calculations have been rounded to the nearest thousand. We can evaluate Original Furnishings’ 2022 and 2021 Return on Assets in a number of ways. First, we can compare the ratio across time. That is, did its performance improve? The decrease from 15.9% in 2021 to 13.8% in 2022 suggests a decline in profitability. The ratio tells us that in 2021 Original Furnishings generated 15.9 cents on every dollar invested in assets and in 2022 it generated 13.8 cents on every dollar invested in assets. Then we can compare the ratios with those of another operator in the industry, Artistry Furniture. In both 2021 and 2022, Original Furnishings’ Return on Assets is below that of Artistry Furniture’s.

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  Financial Accounting

  Reporting, Analysis and Decision Making

  • Shirley Carlon, Rosina McAlpine, Chrisann Lee, Lorena Mitrione, Ngaire Kirk, Lily Wong(Authors)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  Return on Assets An overall measure of profitability is the Return on Assets (ROA). This ratio is calculated by dividing profit by average assets. (Average assets are commonly calculated by adding the beginning and ending values of assets and dividing by 2.) Profit refers to profit after income tax unless stated otherwise. The Return on Assets indicates the amount of profit generated by each dollar invested in assets. Thus, the higher the Return on Assets, the more profitable the entity. Selected figures from the 2022 statement of profit or loss for Artistry Furniture are presented in figure 1.24. The 2022 and 2021 Return on Assets of Original Furnishings and Artistry Furniture Limited (entities operating in the same industry) are presented in figure 1.25. FIGURE 1.25 Return on Assets Return on Assets = Profit Average total assets ($’000) 2022 2021 Original Furnishings $35 900 ($287 370 + $233 280)∕2 = 0.138:1 or 13.8% $38 875 ($233 280 + $255 050)∕2 = 0.159:1 or 15.9% Artistry Furniture $16 600 ($65 250 + $51 840)∕2 ∗ = 0.284:1 or 28.4% $9 450 ($51 840 + $41 472)∕2 ∗ = 0.203:1 or 20.3% *Amounts used to calculate average assets are taken from the statement of financial position (see figure 1.27). Total assets in 2020 were $41 472 000. Also note that amounts in the ratio calculations have been rounded to the nearest thousand. We can evaluate Original Furnishings’ 2022 and 2021 Return on Assets in a number of ways. First, we can compare the ratio across time. That is, did its performance improve? The decrease from 15.9% in 2021 to 13.8% in 2022 suggests a decline in profitability. The ratio tells us that in 2021 Original Furnishings generated 15.9 cents on every dollar invested in assets and in 2022 it generated 13.8 cents on every dollar invested in assets. Then we can compare the ratios with those of another operator in the industry, Artistry Furniture. In both 2021 and 2022, Original Furnishings’ Return on Assets is below that of Artistry Furniture’s.

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  The Economist Guide To Analysing Companies 6th edition

  • Bob Vause(Author)
  • 2014(Publication Date)
  • Economist Books

    (Publisher)

  The holy grail of financial analysis is the discovery of a single foolproof measure of company performance. EBITDA can be useful as part of a detailed analysis of a company, but there are flaws in its claimed perfection. EBITDA ignores the cost of non-current assets employed in a business, yet surely these are as much an operating cost as anything else. As a measure of profitability it is a long way from the bottom line of the income statement, and so ignores not only depreciation but also interest and tax. A company delivering an after-tax loss from a huge investment in non-current assets financed by equally substantial borrowings could look quite healthy on an EBITDA basis. A variation on EBITDA is EBITDAR where R is for rental and operating lease expenses. This is sometimes used by retailers as it removes store occupancy expenses to provide a more comparable trading margin.

  Whichever profit is selected, the end result will be the Return on Assets, but each of the possible profits will produce a different level of return. For each ratio the denominator has remained constant but a different numerator has been used. Before making use of a pre-calculated rate of return figure always check which profit has been used to produce the ratio.

  Similar problems can arise in selecting the denominator for the ROA ratio. This could equally well be the total, operating or net assets employed. Whichever figures are used, the end ratio is correctly described as a ROA for the company in question. If the three companies in the example above had used different definitions of profit and of assets, it would not be of any practical benefit to try to draw any conclusions by comparing their rates of return. For this reason, rate of return ratios given in annual reports or by analysts should not be taken at their face value.

  In short, in calculating comparative rates of return it is essential that there is consistency in both the numerator and the denominator in the equation. In other words, you should ensure that each company’s ROA is calculated in the same way.

  Averaging assets

  As soon as a figure for assets or capital is taken from the balance sheet for use in the development of a performance measure there is a problem. The balance sheet provides the financial picture of a company on the final day of its financial year. The income statement is a statement of the company’s ability to generate revenue and profit throughout the financial year. The income statement is dynamic, covering the whole year; the balance sheet is static, showing the position only at the end of the year. The year-end balance sheet incorporates the retained profit appearing at the foot of the current year’s income statement. Any finance raised during the year for investment in operating assets, even in the last few days of the year, appears in the balance sheet as a source of finance and an asset. For the purposes of rate of return ratios, there is a mismatch between the income statement and the balance sheet.

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  Corporate Finance

  Theory and Practice in Emerging Economies

  • Sunil Mahajan(Author)
  • 2020(Publication Date)
  • Cambridge University Press

    (Publisher)

  Short-term lenders prefer liquidity and, therefore, are keen to know the current ratio and the quick ratio. No single ratio or set of ratios can be appropriate for all occasions and purposes. The ratios we calculate and analyse should be appropriate for our objectives, be it performance evaluation, credit analysis or equity investment. Ratios are just numbers that tell us nothing by themselves. The interpretations of these numbers is critical and we must compare ratios across industries and over time in order to draw legitimate conclusions. Let us try and look at ratios differently, basing our analysis on the return on equity (ROE). It is a key parameter of performance. Given the risk profile of the company, managers try to maximize the return investors get on their equity investments. Let us see how different ratios dovetail into and capture the ROE. CHAPTER 13 300 | Corporate Finance Return on Equity (ROE) The ROE is defined as the net profit divided by the shareholders’ equity. ROE = net profit/shareholders’ equity. Which can be expanded as follows: ROE = (net profit/sales) * (sales/assets) * (assets/shareholders’ equity). Profit margin Asset turnover Financial Leverage Return on equity is thus determined by the following three parameters: 1. Profit margin: It is the difference between the sales price and the cost of the products. In a sense, this is the basic reason for the existence of the company; the fact that its products create value and thus are sold at a price that is higher than the cost. Every company tries to increase the margin on sales and, usually, the higher the profit margin, the better the performance. 2. Asset turnover: Investments of the company are in the form of long-term assets and net working capital. These assets are essential for running the business. The sales that can be generated from the invested capital determine the asset turnover. Higher the sales that can be generated with the assets, the better the performance.

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  Business Ratios and Formulas

  A Comprehensive Guide

  • Steven M. Bragg(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  By avoiding the opinions of the production staff and relying instead on a quantitative comparison of capacity levels and available equipment, the CFO has determined that there are three extra band saws and five extra belt sanders, with a combined cost of $85,000. With this information, the CFO calculates the return on operating assets as:

  Cautions: The specific assets included in the denominator can be subject to a great deal of interpretation, since managers realize that any assets not included in it will eventually become targets for elimination. The list of assets used should consequently be carefully reviewed, preferably with the industrial engineering staff, to ensure that each asset has a direct role in the production of revenue.

  RETURN ON EQUITY PERCENTAGE

  Description: This calculation is used by investors to determine the amount of return they are receiving from their capital investment in a company. This is a commonly used measure, but can be misleading, as discussed in the Cautions section.

  Formula: Divide net income by total equity. To obtain a better picture of the ability of a company to generate a return from operating activities only, the measure can be modified to be net income from operations divided by total equity. The basic formula is:

  Example: The president of the Lounger Chairs Furniture Company has been provided with a bonus plan that is largely based on the increase achieved on return on equity for the shareholders. There is $1,000,000 of equity on the books, of which $400,000 is closely held and the other $600,000 is held by a variety of small investors. The president estimates that it will be possible to buy back $300,000 of the stock from small investors by obtaining a loan that has an after-tax interest rate of 8%. The president compiles the information in Table 7.3 to see if the stratagem makes sense.

  TABLE 7.3

  Before Stock Buyback	After Stock Buyback
  Sales	$5,000,000	$5,000,000
  Expenses	$4,850,000	$4,850,000
  Debt interest expense	—	$24,000
  Profits	$150,000	$126,000
  Equity	$1,000,000	$700,000
  Return on equity	15%	18%

  The strategy appears to be a good one. Though expenses will be driven up by the interest cost of the debt, the amount of equity will be reduced to such an extent that the return on equity will increase by 3%. Before implementing this strategy, though, the president should investigate the company's ability to generate enough cash flow to pay off or at least maintain the debt.

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  Accounting

  Business Reporting for Decision Making

  • Jacqueline Birt, Keryn Chalmers, Suzanne Maloney, Albie Brooks, David Bond, Judy Oliver(Authors)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  These limitations can relate to the quality of the financial statements and the data disclosed (or not disclosed). Comprehensive and effective fundamental analysis considers information beyond, and in addition to, reported financial numbers. In particular, environmental, social and governance performance is becoming increasingly important. SUMMARY OF RATIOS Ratio Calculation Interpretation Profitability ratios Return on equity (ROE) Profit available to owners Average equity × 100 Measures the rate of return earned on equity provided by owners Return on Assets (ROA) Profit (loss) Average total assets × 100 Measures the rate of return earned as a result of investment in assets Gross profit margin Gross profit Sales revenue × 100 Measures gross profitability per dollar of sales revenue Profit margin Profit (loss) Sales revenue × 100 Measures net profitability per dollar of sales revenue (continued) CHAPTER 8 Analysis and interpretation of financial statements 323

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  Available until 8 Dec |Learn more

  The Meaning of Company Accounts

  • Walter Reid(Author)
  • 2018(Publication Date)
  • Routledge

    (Publisher)

  This is a useful format for learning, but is rare in practice. Far more common is the format shown for ABC Trading Limited above, which deducts long-term loans (600) from ‘Total assets less current liabilities’ (2 200), to give a figure equal to capital and reserves (1 600) (= ‘Shareholders’ funds’). 23 PYRAMID OF RATIOS Return on net assets is a useful measure for internal management control purposes because it readily splits into a number of elements. The first level of division is into two basic parts: Return on Net Assets = Profit Margin x Net Asset Turnover This means: Profit Profit Sales ---------------------------— _ --------------------x --------------------------------------Net Assets Sales Net Assets ‘Profit’ here is the ‘profit before interest payable and tax’ (PBIT). Using the figures for ABC Trading Limited, the breakdown is: 440 440 4000 2 200 ' 4000 X 2 200 20.0% = 11.0% x 1.82 The 11.0 per cent profit margin on sales is a common measure of performance. The concept of ‘net asset turnover’ may be less familiar, but it is a useful way of thinking about the use of capital. The number ‘1.82’ can be thought of as the number of times that capital is being turned over in sales revenue in a period. Perhaps more concretely, it is the number of pounds’ worth of sales that each pound of investment generates on average in a year. The basic division of return on net assets into profit margin and net asset turnover can go further to form a ‘pyramid’ of ratios, as shown on the right. Changes in higher level ratios are ‘explained’ (or analysed) in terms of changes in a number of lower level ratios. Thus, for example, one can split the ratio ‘Operating Expenses as a percentage of Sales’ between the various different kinds of operating expenses; or any given ratio for the whole company (say, gross profit margin on sales) can be split between various divisions or product lines of the company.

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  Business Ratios and Formulas

  A Comprehensive Guide

  • Steven M. Bragg(Author)
  • 2010(Publication Date)
  • Wiley

    (Publisher)

  Description: A company is deemed efficient by investors if it can generate an adequate return while using the minimum amount of assets to do so. This also keeps investors from having to put more cash into the company and allows the company to shift its excess cash to investments in new endeavors. Consequently, the Return on Assets employed measure is considered a critical one for determining a company’s overall level of operating efficiency.

  Formula: Divide net profits by total assets. Although the assets figure is sometimes restricted to just fixed assets, it should include accounts receivable and inventory, since these areas can be major users of cash. The amount of fixed assets included in the denominator is typically net of depreciation; it can also be recorded at its gross value, as long as the formula derivation is used consistently over multiple time periods, thereby ensuring consistent long-term reporting. The formula is:

  Example: Mr. Willston is the new owner of Southern Sheet Metal, a metal stamping company. He purchased the company for $3 million, and wants to retrieve as much of these funds as possible by increasing the company’s Return on Assets. He has the controller collect the information about company income and assets that is shown in Table 7.1 .

  Based on the table, the calculation of net assets employed is:

  Table 7.1

  Year-end Results	Days on Hand
  Sales	$3,070,000
  Net income	$215,000	—
  Accounts receivable	$512,000	60
  Inventory	$461,000	90
  Fixed assets	$1,950,000	—
  Total assets	$2,923,000	—

  As the new owner, Mr. Willston is not certain which of the fixed assets can be safely eliminated while maintaining productive capacity. However, he is sure that the days of accounts receivable and inventory, as noted in the table, are much too high. Accordingly, he improves collection activities and early payment discounts and drops the outstanding accounts receivable balance from 60 days to 45, reducing this asset to $384,000. He also installs an improved inventory management system, reducing the on-hand inventory balance from 90 to 60 days, which reduces this asset to $309,000. By taking these actions, he has eliminated $280,000 of assets, which he can take out of the business. He has also improved the net assets employed measurement to 8.1%, which is calculated as:

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  Initial Public Offerings (IPO)

  An International Perspective of IPOs

  • Greg N. Gregoriou(Author)
  • 2011(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  In Figure 7.4 we can observe the evo-lution of accounting earnings from the year of the IPO to three following years. As illustrated in Figure 7.4(A), the Return on Assets (ROA) presents its maximum value at the year of the offering to revert after that in subsequent years. Moreover, this pattern is detected both for mean and medians values. In order to control for the normal amount of mean reversion in ROA, in Figure 7.4(C) we plot the performance of IPO firms’ ROA in excess from their matched sector–year ROA medians of non-IPO firms. We verify how the matched ROA reproduces the same pattern in mean and medians. These results suggest an effort of IPO firms to manage upward their earnings in the event year, reverting into a clear decline in the following years. Panels B and D of Figure 7.4 show the time profile of the extraordinary and non-recurrent items (REX) of IPO firms’ net income. The pattern observed for mean values is sim-ilar to that observed in ROA, before and after adjusting by the matched sector–year non-IPO firms. Nevertheless, for median values the evolution is not so clear. These results suggest that there are singular IPO firms that report unusually high REX at the event year in order to maximize the net income reported, but it is not a general-ized practice between IPO firms. This is consistent with the different accounting choices for REX and ROA. The REX is clearly observable by investors, whereas earn-ings management practices with ROA, through discretionary accruals to influence working capital accounts, is hardly noticeable by investors. Table 7.3 reports statistical significance of ROA performance. In panel A, we can observe a progressive decline in ROA after the offering that is significantly different from zero for the 1-, 2-, and 3-year periods.

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  Integrated Bank Analysis and Valuation

  A Practical Guide to the ROIC Methodology

  • S. Chen(Author)
  • 2013(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  In understanding what makes a bank tick, we have found it useful to break down the return on invested capital analysis into two main parts: (1) the bank’s operating performance on a risk-adjusted basis (measured as underlying returns on risk-weighted assets, RORWAs), and (2) its capital leverage (measured as RWA/Invested Capital). Multiplying these two factors together gives us Return on Invested Capital (ROIC).

  In many ways, this echoes a DuPont-style ROE analysis. The DuPont approach breaks down ROE (return on equity) into its main components with the following formula: DuPont ROE decomposition:

  ROE =

  (Net Income/Sales) × (Sales/Total Assets) × (Total Assets/Shareholders’ Equity)

  Where Net Income/Sales is the net profit margin, Sales/Total Assets is the asset turnover, and Total Assets/Shareholders’ Equity is the leverage component. Similarly, the ROIC approach breaks down ROIC (return on invested capital) into its main components with the following formula: ROIC decomposition:

  ROIC =

  (Net Returns/Risk-Weighted Assets) × (Risk-Weighted Assets/Invested Capital)

  Where Net Returns/Risk-Weighted Assets is the net risk-adjusted profit margin, and Risk-Weighted Assets/Invested Capital is the capital leverage component.

  Looking at it in this way, analysing bank performance tends to be a discussion of either (1) what‘s driving changes in operating performance (RORWA components), or (2) whether capital leverage (RWA/Invested Capital ratios, and within Invested Capital the debt capital/equity capital funding mix) is rising or falling. We have found this a simpler, clearer way of analysing a bank’s performance.

  The fundamental link between analysis and valuation: value creation

  The key link between analysis and valuation in the ROIC methodology is value creation (or destruction). If a bank’s return on invested capital (ROIC) is higher than the cost of that capital (WACC), then it is deemed to be creating value in that period; if its ROIC is below its WACC, it is deemed to be destroying value.

  The ROIC methodology adds up a bank’s future value creation/destruction period-by-period, discounting it back to net present value. This net present value of future value creation/destruction is then added to (or subtracted from) current invested capital to derive a fundamental valuation for the bank.

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