Question

We spent a lot of time in class discussing Return on Assets (ROA) and in particular the DuPont method.   This is of course a key measure used externally to compare companies and their relative performance and internally to measure management on their effective use of assets.

However it is not a perfect measure.   Different companies have different strategies.   Let’s use the Jewelry business as a first example.   First consider Tiffany. They are very exclusive and expensive and I would guess that on average they have a higher quality of diamonds than say Kay. On the other hand, Kay while having a range of diamonds, does sell some high quality as well and ultimately let’s face it, at some point a diamond is, well just a diamond.  At least I think?

But they have very different strategies. Tiffany sells at a very high profit margin, but is willing to have much lower volumes and turnover of their assets which for a Jeweler is pretty much inventory. Where as Kay, moves inventory fast.   There are in many more and less exclusive locations, have more sales and discounting, so they would have a lower profit margin, but turn their inventory over much faster. Nevertheless, both companies have the opportunity to have a good return on their assets, but with different strategies and the DuPont method would call that out very quickly.

Another situation that can happen is that two similar companies, with similar output and similar net income all else being equal, could have very different strategies.   One company may rely on automation, read that as robotics and accordingly have a very high asset base.   The other may rely on a labor intensive model that uses people but not nearly as many assets.

You are the analyst and are asked to compare the two enterprises and have ROA high on your list of analytics. Because you now know you need to dig deep into Financial Reporting to get the whole story, you realize this difference in strategy and realize that the labor intensive company is going to simply by nature have a higher ROA, since the assets in the denominator are lower and from there it is just the math.

So now what to do.   Can you think of alternative ways to compare the two companies.   

Answer 1

Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea as to how efficient a company's management is at using its assets to generate earnings. Return on assets is displayed as a percentage.

KEY TAKEAWAYS

• Return on Assets (ROA) is an indicator of how well a company utilizes its assets, by determining how profitable a company is relative to its total assets.
• ROA is best used when comparing similar companies or comparing a company to its previous performance.
• ROA takes into account a company’s debt, unlike other metrics, such as Return on Equity (ROE).

The Basics of Return on Assets—ROA

Businesses (at least the ones that survive) are ultimately about efficiency: squeezing the most out of limited resources. Comparing profits to revenue is a useful operational metric, but comparing them to the resources a company used to earn them cuts to the very feasibility of that company's’ existence. Return on assets (ROA) is the simplest of such corporate bang-for-the-buck measures.

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

Higher ROA indicates more asset efficiency.

How to Use ROA to Judge a Company's Financial Performance

Sure, it's interesting to know the size of a company, but ranking companies by the size of their assets is rather meaningless unless one knows how well those assets are put to work for investors. As the name implies, return on assets (ROA) measures how efficiently a company can squeeze profit from its assets, regardless of size. In this article, we'll discuss how a high ROA is a tell-tale sign of solid financial and operational performance.

KEY TAKEAWAYS

• Return on assets (ROA) is an indicator of how profitable a company is relative to its assets or the resources it owns or controls.
• Investors can use ROA to find good stock opportunities because the percentage shows how efficient a company is at using its assets to generate profits.
• An ROA that rises over time indicates the company is doing a good job of increasing its profits with each investment dollar it spends.
• A falling ROA indicates the company might have over-invested in assets that have failed to produce revenue growth, a sign the company may be trouble.