Question

The company that you are working for as a CFO is experiencing poor profitability. This was evident in the Rate of Return on Assets, which was only 4% compared to the average industry of 15%.

1. What reasons that may stand behind this relatively low rate on Assets? And what Course of Action that you may suggest to the Board of Directors to improve this rate?
2. In your opinion, how would this low income or return would affect the liquidity of the firm? And how you plan to respond to any liquidity problem the firm may be facing?

Answer 1

a) ROA is calculated by dividing a company’s net income by total assets.

i.e,

Return on Assets= Net Income​/ Total Assets

This shows the earning generated from the invested capital.

A business with a low profit margin and low return on assets, or ROA, conjures up visions of a dusty operation with few customers, high costs and fossilized prices. This is not an encouraging omen of ongoing survival.

Following steps can be taken to correct such situation - recognize the existing problem, and analysis of financial ratios can help. Profit margin and ROA ratios can point to inefficient operations and unprofitable outcomes. Improvement in these ratios can confirm your business is successfully addressing these problems.

Further,

A company might have a low ROA for several reasons. Overcapacity hurts ROA, because assets are sitting idle part of the time. If a company has overcapacity but strong profit margins, a price cut might increase market share and capacity utilization. However, here this company has weak profit margins, cost cutting and asset sales might be in order.

2. Fixed costs might be too high. One option is to outsource some of the operations to low-cost producers and sell off the assets no longer need. This might boost the company’s ROA by increasing the numerator -- net income -- while reducing the denominator, average assets. If one of the divisions fails to cover its fixed costs, this company might consider selling it to a company with a better cost structure.

b) Low income/ return would imply less capital being invested in the business i.e a company will not be able to meet its expences or pay of its debts. Hence, its liquidity will decrease.

*Steps to improve the liquidity -

To increase liquidity means increasing your business's cash flow, often so that cash on hand is sufficient to pay current liabilities. When solvency concerns arise, management can improve liquidity through various means. Restructuring debt, utilizing idle funds and reducing overhead are three possible means of increasing cash. Cutting back on small expenses, selling unneeded assets and collecting outstanding accounts can further improve a liquidity ratio.

* In case you need a detailed explaination to the above steps do respond.