Question

Investors and lenders place significant importance on management's effectiveness in generating a high return on assets (ROA). Explain how ROA is also important for managers' analysis of its own performance, particularly when ROA is disaggregated

Answer 1

Return on assets (ROA) is a helpful measure of a company’s profitability. In its most basic form, ROA is a ratio between net income and average assets, i.e. it indicates the return the company is earning from its assets. While ROA is a valuable indicator for investors, it is just as valuable for company managers. This is because ROA indicates how successful managers are in acquiring and using investments on behalf of shareholders.ROA is particularly useful for managers when it is disaggregated into more focused, meaningful components.

Return on assets can be ‘disaggregated’ into profit margin (PM), which measures profitability and asset turnover (AT), which measures efficiency or productivity.

The ratio of net income to sales is called ‘profit margin’ and the ratio of sales to average assets is called ‘asset turnover.’ The profit component reflects the amount of profit from each dollar of sales, and the productivity component reflects the effectiveness in generating sales from assets.This disaggregation yields additional insights into the factors that cause overall ROA to change during the year. It could be that the company is more or less profitable or that the company is more or less efficient or both. This disaggregation provides more informative than just knowing that ROA has increased or decreased during the year.