The return on assets (ROA) is a commonly used profitability ratio that shows how effectively a company uses its assets to generate profit.
The higher ROA, the better a company's resource utilization is, or in other words, the more profitable it is. ROA is commonly expressed as a percentage numbers and is utilized in all screeners and charts throughout the site in percentage.
The formula to derive ROA
Net Profit - Net Profit or Net Income is measured by sales minus Cost of goods sold, general and administrative expenses, operating expenses, other expenses, depreciation, interest, and taxes, etc. Net Profit is found in the Income statement of the companies.
Average Assets - Average Assets are the sum of total assets of the current year and previous year divided by two. And it is found in the company's Balance sheet.
Example of Return on Assets: Bajaj Auto Limited Reported Net Income as Rs. 4857.02 Cr and Total Assets of the company Rs. 33601.71 Cr for the financial year.
The ROA for Bajaj Auto, as per the formula [ROA = (Net Profit / Average Assets) x 100] is calculated as (4857.02 / 33601.71) x100 = 14.45%.
ROA ratio shows how well a company manages its resources to generate profit.
Investors should look for higher ROA, as ROA with a high ratio indicates that the company is profitable.
ROA is also calculated on MRQ and TTM basis.
Investors should look for other relative ratios to ROA before making an investment decision.
ROA is an independent metric, but while looking at ROA the following points should also take into consideration:
1. Higher ROA means good utilization of Assets. As a general figure ROA with 5% is good, and above 20% is considered excellent returns.
2. A well-established company of a mature industry is likely to give higher ROA.
3. For a heavy capital industry ROA is expected to increase over a period of time.
4. A new organization/start-up or a company heavily investing in the infra/expansion may give lower ROA. In such a case, analysts have to consider additional factors.
5. ROA values also are cyclical. I.e., the ROA of companies of a similar sector may be rising or falling together.
6. The ROA of the company should be compared with its peers. For example, FMCG with an all-weather demand should not be compared with metal which is more cyclical.
How to use ROA effectively
1. Investors should be looking company with a High ROA
2. Lower ROA, but with continuous rising ROA, indicates the company is becoming incrementally efficient in generating profit from its resources. This is a plus point.
3. Even with High ROA investors should compare with their peers before the trading decision. Never invest in laggards as in a downturn they are affected most badly.
4. Falling ROA is alarming unless there is huge expansion going on.
5. Since ROA is calculated every quarter, it is good to see the price change factor at the time of investment.
6. ROA is an independent metric, but we cannot look for only one financial metric before making an investment decision. ROA may go along with Asset Turnover Ratio, Debt to Asset, Asset to Shareholders Equity, Return on Equity (ROE)
Scenarios we must consider while looking at ROA
Good Scenario: If particular company's ROA gain suddenly, then it can be due to increase in company's asset.
Bad Scenario: Sudden gain in ROA also can be due to fall in company's assets.
Good Scenario: It is good fall in ROA if it is due sudden gain in assets of the company, as it is new investment in assets.
Bad Scenario: Sudden fall in ROA of the company can be also due to fall in Net Income.
Negative ROA are generally because of negative Net Income, and it indicates that is not effectively using its assets to generate income.
This metric is used by investors to analyse how profitable a company is in relation to its assets.
If the company has a ROA above the ideal ratio or industry average, but its ROE is negative. This scenario comes in when the company is making a profit using its assets but has a huge burden of debts. Investors should avoid these type of company.