Why is return on assets important

Bernstein, Leopold A. Analysis of Financial Statements. New York: McGraw-Hill, Casteuble, Tracy. July Davidson, Steven. October Gill, James O. Financial Basics of Small Business Success. Kremer, Chuck, and Ronald J. International Thompson Publishing, Kristy, James E.

Finance without Fear. New York: American Management Association, Larkin, Howard. In general, the higher the value, the better a company is.

Return on assets measures profit against the assets a company used to generate revenue. It is an important indicator of the asset intensity of a company. A lower ratio means a company is more asset-intensive, and vice versa. Additionally, a more asset-intensive company needs more money to continue generating revenue.

It is also very important for management to measure its performance against its planned business goals, or market competitors. Expressed as a percentage, ROA identifies the rate of return needed to determine whether investing in a company makes sense. Measured against common hurdle rates like the interest rate on debt and cost of capital, ROA tells investors whether the company's performance stacks up.

For example, investors can compare ROA to the interest rates companies pay on their debts. If a company is squeezing out less from its investments than what it's paying to finance those investments, that's not a positive sign. By contrast, an ROA that is better than the cost of debt means that the company is pocketing the difference. Similarly, investors can weigh ROA against the company's cost of capital to get a sense of realized returns on the company's growth plans.

A company that embarks on expansions or acquisitions that create shareholder value should achieve an ROA that exceeds the costs of capital. Otherwise, those projects are likely not worth pursuing. Moreover, it's important that investors ask how a company's ROA compares to those of its competitors and to the industry average. There is another, much more informative way to calculate ROA.

If we treat ROA as a ratio of net profits over total assets, two telling factors determine the final figure: net profit margin net income divided by revenue and asset turnover revenues divided by average total assets.

If the return on assets is increasing, then either net income is increasing or the average total assets are decreasing. A company can arrive at a high ROA either by boosting its profit margin or, more efficiently, by using its assets to increase sales. By knowing what's typical in the company's industry, investors can determine whether or not a company is performing up to par. This also helps clarify the different strategic paths companies may pursue—whether to become a low-margin, high-volume producer or a high-margin, low-volume competitor.

ROE is arguably the most widely used profitability metric, but many investors quickly recognize that it doesn't tell you if a company has excessive debt or is using debt to drive returns. Investors can get around that conundrum by using ROA instead.

Consequently, everything else being equal, the lower the debt, the higher the ROA. Still, ROA is far from being the ideal investment evaluation tool. There are a couple of reasons why it can't always be trusted.

For starters, the "return" numerator of net income is suspect as always , given the deficiencies of accrual-based earnings and the use of managed earnings. Also, since the assets in question are the sort of assets that are valued on the balance sheet namely, fixed assets , not intangible assets like people or ideas , ROA is not always useful for comparing one company against another.

Some companies are "lighter," with their value based on things such as trademarks, brand names, and patents, which accounting rules don't recognize as assets. A software maker, for instance, will have far fewer assets on the balance sheet than a car maker. As a result, the software company's assets will be understated, and its ROA may get a questionable boost. ROA gives investors a reliable picture of management's ability to pull profits from the assets and projects into which it chooses to invest.

The metric also provides a good line of sight into net margins and asset turnover, two key performance drivers. ROA makes the job of fundamental analysis easier, helping investors recognize good stock opportunities and minimizing the likelihood of unpleasant surprises.