Question

3 reasons why ROA must be interpreted with care

1000words bcuz of 50 marks

Answer 1

Return on Assets (ROA)- Meaning, Significance, limitations, For Industries-Formulas, conclusions, exceptions.

Return on Assets (ROA) provide signals of the company profitability as compare to its total assets. ROA give signs to an investors and analyst that how well a company is using it's assets to maximize earnings and return on Assets must be shown in percentage and ROA shows how efficiently a company can convert the money used to purchase assets into net income or profits.

Return on Assets is calculated by dividing the Net Income with company's total assets.

Return on Assets = Net Income / Total Assets

For example assume Ana and Len both started pizza stands business together :

Ana spends $2500 for a grill and Len spends $25000 on main Stand and Assumes that these are the only assets in the business and Ana over some period of time had earned $ 250 and Len earned $ 1300, Ana earned more value of amount of $ 1300 but Len is more efficient in earning by using the above formula we see Ana's ROA as $ 250 / $ 2500 * 100 = 10 %

And Len's ROA as $ 1300 / $25000 * 100 = 5.2 %

The Ana's ROA is more efficient then Len's ROA.

How Len's ROA is less than Ana's ROA, this is because Len did not able to utilize his assets more efficiently than Ana and due to this Len did not get more earnings which leads to the fall in percentage of Len's ROA is 4.8 %.

Importance of Return on Assets

ROA tells what earnings were generated from the deployed total assets. ROA percentage gives investor or an Analyst an idea that how effectively the company is converting net income from its optimum utilization of the deployed assets. There is a direct relationship between the higher ROA and Company earnings, Higher the Return on the Assets percentage the higher is the earnings of the company with less investment.

You must notice in the formula that net income is divided by its total assets and what actually the total assets means are they only subject to the current assets and fixed or non-current assets of the company but no the total assets also includes the total liabilities and share holder's equity because both of these types of the financing are used to fund the operations of the company.

And ROA in case of public sector companies can be differ from the private sector companies and ROA is highly dependent on the industry and it is best to compare it against a company previous ROA.

Limitations of Return on Assets

The biggest drawback of ROA is that it can not be used across industries, such as the technology industry and another industry like oil drillers will have different calculations or assets bases and industries which are asset intensive would not generate that much income compared to the industries which are not asset intensive. For example, if we take into account an auto industry, to produce auto and as a result of that, profits; the industry first needs to invest a lot in the assets. Thus, in case of auto industry, the ROA would not be that higher.

More Intesive and less Asset-intensive

• The lower the return on assets, the more asset-intensive a company is. An example of an asset-intensive company would be an airline company.
• The higher the return on assets, the less asset-intensive a company is. An Example of an asset-light company would be a software company.

Implications for Non-financial companies

For non-financial companies, debt and equity capital is strictly separated, as are the returns to each interest expense is the return for debt providers, net income is the return for equity investors. So the common ROA formula mix up things up by comparing returns to equity investors (net income) with assets funded by both debt and equity investors (total assets). These formulas do not ignore taxes so that if tax implications are there we can use the below mentioned formulas:

ROA vary 1: Net Income + [Interest Expense*(1-tax rate)] / Total Assets

ROA vary 2: Operating Income*(1-tax rate) / Total Assets

There are two acceptable ways to calculate ROA:

1.) Return on assets ratio = Net Income / Average total assets.

2.)  Retrun on assets =Net profit margin x Asset turnover

To have ROA, first need to calculate the net profit margin. The net profit margin is equal to how much net income or profit is generated as a percentage of revenue

Net profit margin = Revenue -COGS (cost of good sold)-Expenses - Interest-Taxes / Revenue

The Average total assets are usually used because assets total can be differ over some period time (over months). simply add the opening assets balance and closing assets balance and divide it by two. A positive ROA ratio usually indicates an upward profit trend as well. ROA is most useful for comparing companies in the same industry as different industries use assets differently.

How ROA benefits to the Investors :

ROA gives investors a reliable picture of management's ability to pull profits from the assets and projects into which it chooses to invest. ROA makes the analysis easier, helping investors recognize good stock opportunities and minimizing the unpleasant surprises.

Impact of ROA on Banks

Banks tend to have a large number of total assets on their books in the form of loans, cash, and investments. A large bank could easily have over $1.8 trillion in assets while putting up a net income that's similar to companies in other industries. Although the bank's net income or profit might be similar to an unrelated company and the bank might have high-quality assets, the bank's ROA will be lower. The larger number of total assets must be divided into the net income, creating a lower ROA for the bank.

Bank calculate formula same as mentioned at the top.

Exception to ROA

In most cases, the bulk of the difference between return on assets and return on equity is debt. A company that borrows a lot of money is going to have a significant gap between its total assets and its total equity, and that will convert into a big difference in the "return" ratios. If a company had borrowed so much that its liabilities actually exceed its assets, then the company has negative equity. In that case, return on assets will be larger than return on equity, because return on equity will be a negative number.