Question

Explain how ROA ratio would be affected if a retail company was able to negotiate a better purchase price for a line of clothes for inventory.

Answer 1

Return on Assets=ROA=Net Income/Total assets

Assume a retail company has following Income and assets:

Annual Sales Quantity =100000 units

Sales Price per unit=$100

Annual Sales=100000*100=$10,000,000

Assume Purchase price per unit =$80

Cost of goods sold =$8,000,000

Other Operating expenses=$1,000,000

Annual Income =$10,000,000-$8,000,000-$1,000,000=$1,000,000

ASSETS:

Assume Inventory =3 months of goods sold

Inventory =$8,000,000*(3/12)=$2,000,000

Fixed Assets =$4,000,000

Total Assets =$2,000,000+$4,000,000=$6,000,000

Return on Assets =Income/Total assets=$1,000,000/$6,000,000=16.67%

If the retail company is able to negotiate a better Purchase Price:

Negotiated Price per unit =$70 per unit

Cost of goods sold =$70*100000=$7,000,000

Changed Annual Income =$10,000,000-$7,000,000-$1,000,000=$2,000,000

Changed Inventory =$7,000,000*(3/12)=$1,750,000

Changed Total Assets=$1,750,000+$4,000,000=$5,750,000

Changed Return on Assets (ROA)=$2,000,000/$5,750,000=34.78%

ROA has increased.

If you negotiate a better price:

1. Income will increase

2. Inventory will decrease . Consequently total assets will decrease.

As a result, ROA ratio will increase