Understanding the Return on Assets Formula

You’ve found our guide to understanding, measuring, and improving Return on Assets!

Return on Assets (ROA) is an important financial metric that measures a company’s ability to generate profit from its assets. 

Understanding and optimizing ROA can impact your business’s efficiency and profitability, making your business more attractive to lenders, investors, or buyers.

In this guide, we’ll delve into what ROA signifies, how it’s calculated, and why it stands out among other financial indicators like Return on Equity (ROE) and Return on Investment (ROI). 

This guide is also related to our articles on financial ratios formulas, understanding unearned revenue and how to calculate break-even point in sales.

This guide covers: 

• Understanding Return on Assets (ROA)
• How to Calculate ROA
• What’s an Asset?
• What is Net Income?
• What is a good ROA
• ROA vs similar ratios
• Strategies to Improve ROA

Let’s get started!

Understanding Return on Assets (ROA)

Return on Assets is part of several key financial ratios that businesses use to measure their financial performance. ROA provides insight into the company’s ability to extract profit from its assets. 

This ratio is used to guide investment and operational decisions. It is a ratio that lenders, banking institutions, investors or buyers use to understand how efficient a business is.

How to Calculate ROA

The return on assets formula is calculated like this

Return on Assets = Net Income / Total Assets

As an example, let’s say Company A has $10,000 in Net Income and $250,000 in Assets. Company B has $5,000 in Net Income and $75,000 in Assets. 

Company A

• Return on Assets = $10,000 divided by $250,000
• Return on Assets =  4%

Company B 

• Return on Assets = $5,000 divided by $75,000
• Return on Assets = 6.7%

These results mean that every dollar that the company invested in assets generated 4 cents (Company A) and 6.7 cents (Company B) of net income. This means that Company B did better at converting their assets into profit. 

What is an Asset?

An asset is a resource owned by a business, expected to produce economic benefits or value in the future. There several kinds of assets: Current, Fixed, Tangible and Intangible

Current assets

A type of asset that is expected to be converted into cash, sold, or consumed within one year. Current assets include:

• Cash and cash equivalents
• Accounts receivable
• Inventory
• Prepaid expenses
• Other liquid assets that can be quickly turned into cash 

Current assets fund day-to-day operations are a measure of a company’s short-term financial health and liquidity.

Fixed assets

A fixed asset is a long-term tangible piece of property or equipment that a business owns, and is not expected to be converted into cash or consumed within one year. Fixed assets include:

• Buildings
• Machinery
• Equipment
• Vehicles
• Furniture
• Land

Fixed assets are crucial for the production of goods and services.

Tangible assets

A tangible asset is a physical item of value owned by the business. These assets include buildings, machinery, vehicles, inventory, and land. Tangible assets are characterized by their physical form – they can be seen and touched.

Intangible assets

An intangible asset is a non-physical asset that represents legal rights or economic value to a business. Examples include patents, trademarks, copyrights, software created by the company, and brand names. Intangible assets can be sold, transferred, or licensed.

What is Net Income?

Net income is profit generated by the business after subtracting Cost of Goods Sold and all operating expenses from Revenue. There are two kinds of Net Income. 

Net Operating Income (NOI) subtracts operating expenses (rent, payroll, software fees etc.) from Revenue. 

Net Income subtracts all operating expenses and additional expenses that don’t contribute to regular operations (depreciation, amortization, taxes). 

For the purposes of measuring ROA however, we are using NOI, but labeling it Net Income. In other words, Net Income for ROA doesn’t include depreciation, amortization, or tax expense.

By focusing on Net Operating Income (NOI) as our version of Net Income for ROA calculations, we’re honing in on the profitability derived strictly from the business’s day-to-day activities. This approach provides a clearer picture of operational performance, excluding the noise of non-operational financial activities. 

What is a good Return on Asset number?

Over 5% is generally considered a good ROA, and over 20% is considered excellent. But each industry has their own ROA benchmarks that vary widely depending on how many assets are needed to produce revenue. 

Asset heavy industries like manufacturing, construction, mining, and a real estate portfolio will generally have ROA on the lower range, because these businesses require substantial capital investments (aka lots of expensive assets) to produce revenue. 

A medium range of ROA industries would be something like retail or restaurants. 

1. A retail store could rent their retail space instead of owning it, and inventory would likely be the most expensive asset on the Balance Sheet. 
2. A restaurant may also lease their space and will need some significant assets such as kitchen equipment, tables and chairs, but these assets will be less expensive than equipment needed for a car manufacturing company, for example. 

Companies within the higher range of ROA expectations will be service companies (advertising firms, consulting firms, lawyers and accountants etc.) 

While there may be some larger assets (such as owning their office building), service businesses don’t require many assets in order to generate revenue. 

Technology companies would be another example of higher ROA, depending on the cost of creating the software (software is an intangible asset)

Here at the various industries ranked by average Return on Assets

• Technology 14.05 % 
• Healthcare 13.40 % 
• Services 7.39 % 
• Retail 6.16 % 
• Transportation 4.92 % 
• Real Estate— 3.50%
• Energy— 1.70%
• Auto Manufacturers— 1.50%

Info provided by CSI Market & Risk Concern. 

The key takeaway for business owners is to not just aim for a “good” ROA in a vacuum but to strive for a competitive ROA within your sector. Don’t compare your retail store to a technology company – make sure you’re comparing apples-to-apples.

Strategies to Improve ROA

Return on assets will improve when you increase your operational efficiency. What does that mean? It means making sure that the assets on your Balance Sheet are generating as much revenue as you can extract from them. 

Here’s some examples of various types of assets and how they can be made more profitable. 

Cash

If you’re sitting on more cash than needed to fund current operations and provide a healthy runway, you should consider making investments in growth. You should figure out how many months of cash you want to keep in reserves depending on how many months of runway you want. If your business is cyclical with periods of high and low revenue, you’ll probably want more cash on hand to fund you through the lean months. 

After you determine how much cash you want on hand, look for investment opportunities like:

• investing in new product development
• marketing campaigns to reach new customers
• technology upgrades to improve efficiency
• acquiring smaller competitors to expand your market share

Accounts Receivable

If you’re sitting on a large balance of Account Receivable, can you collect faster from your customers? You could offer a discount if customers pay up front, shorten your collection period (from 60 days to 30 days for example), collect bank or credit card info and move customers to autopay, automate your reminders to customers, or start calling customers regularly to collect on receivables. 

You might also need to send some receivable to collections if you haven’t had success getting the customer to pay, or even write off receivables that you don’t expect to collect. 

Writing off AR will increase your expenses in the short term (bad debt is an expense), but it will improve your Return on Assets in the long run. 

Equipment

Can you sell or dispose of old or obsolete equipment you might still have? Can you upgrade existing equipment to be more productive? Can you rent out equipment that you’re not using all the time to make it a profit center? 

Additionally, consider leasing equipment instead of purchasing it outright to improve ROA and maintain liquidity. 

Inventory

You may have inventory that’s not selling very much. Consider selling that inventory at a discount or limited sale. Inventory that’s not moving is taking up warehouse space and lowering your ROA. You should also be on the lookout for alternate vendors who can provide the wholesale merchandise at a lower price without sacrificing quality. 

Real Estate

If your small business owns property, assess whether all your real estate assets are being fully utilized. Underused or vacant spaces can be transformed into revenue-generating assets through leasing or renting out. 

Additionally, if certain properties are no longer strategic to your business, selling them could provide a capital infusion that can be redirected towards more profitable investments.

Intellectual Property

Review your portfolio of intellectual property (IP) assets, such as patents, trademarks, or copyrights. Licensing your IP to other companies can generate ongoing revenue without significant additional expense. Additionally, enforcing your IP rights can protect against revenue loss from unauthorized use.

Return on Assets vs similar ratios

Return on Assets is part of three important ratios that are typically used in tandem to understand how healthy a business is. The other two ratios are Return of Equity (ROE) and Return on investment (ROI)

Return on Equity

ROE zooms in on the money you and any other owners have put into the business. It’s like ROA’s sibling, but instead of looking at all assets, it’s specifically interested in how well your equity (the money invested in the business) is working to generate profits. Calculate ROE by dividing net income by shareholder equity. 

What’s shareholder equity? Imagine it as the slice of the pie that belongs to you and any other folks who’ve invested in your business. It’s what’s left over when you take all your assets and subtract all your debts (liabilities). Think of it as your business’s net worth or the value that you, as the owner, and any other investors would theoretically get if you decided to close shop and sell everything off.

Return on Investment

ROI is the Swiss Army knife of financial metrics, widely used and super versatile. It measures the profitability of pretty much anything you put money into, from a marketing campaign to a whole new product line. You calculate it by taking the return of an investment (sales generated), subtract it by the cost of the investment, then divide that number by the cost of the investment again. It’s your go-to for answering, “Did this investment pay off?”

Comparing the Three Ratios 

• ROA gives you a bird’s eye view of how effectively your company uses all its resources to make money.
• ROE focuses on profitability from the shareholders’ perspective.
• ROI is your catch-all for evaluating the success of specific investments.

Together, these three ratios offer an important look at your business’s financial performance from different angles. Knowing where you stand with each can help you make smarter decisions about where to invest your resources for the best return.

Conclusion

It’s important to understand your Return on Assets, as this is a measure that tells you (in part) how valuable your company is and how attractive it is to investors or buyers. You might be a numbers person and get excited about digging into your ratios, or you might want to outsource that job and let a pro handle it. 

You’re busy, you have sales to make, employees to manage, and customers to keep happy. 

Rigits can help you figure out your Return on Assets over time (it might fluctuate), benchmark your ROA against the industry standards, offer suggestions on how to make better use of your assets, and help you track progress and evaluate your success.  

Get in touch with us and let’s see how we can make your business more profitable!

Now check out our articles on 12 common bookkeeping mistakes to avoid, bookkeeping vs. accounting, and 21 best tax software, apps & tools in 2023.

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