What is ROA?

Diverse businesses operate with distinctive models, each with its unique dynamics and challenges. Take, for instance, a cab service provider; the essence of their operation lies in the size of their fleet. To amplify profitability, expanding the fleet becomes imperative. However, with each new cab added, comes a significant investment to acquire it. Therefore the individuals in this business constantly try to evaluate the value of each cab and the corresponding profits it generates. In essence, they gauge the returns derived from their assets in relation to the asset's value.

This method of analyzing returns appears to be quite effective, doesn't it? It would be highly beneficial if we could employ a similar approach to enhance our comprehension of a specific company. Well, there is a profitability ratio called Return on Asset (ROA) that helps in doing the exact same. Let us break down the Return on Asset (ROA) ratio and understand it piece by piece in this blog.

Return on Assets (ROA) is a critical financial metric that provides insight into how effectively a company utilizes its assets to generate profits. It is a key component of the DuPont Model.

But what is the Du Pont Model? The Du Pont Model is an important tool to analyze the factors driving the return on equity of a company. I have explained both the Du Pont Model and the ROE in a simplified way in two separate blogs, on www.rachanaranade.com

Moving on, ROA is a powerful tool for investors and analysts to evaluate a company's operational efficiency and financial performance.

The formula for calculating ROA is as follows:

ROA = Net Income / Total Average Assets

As you may have noticed, in the formula, Total Average Assets are used rather than Opening Assets or Closing Assets. In financial analysis, this choice to use average total assets is to get more precise results. This approach acknowledges that a company's asset base might change due to factors like asset transactions, inventory fluctuations, and seasonal sales patterns.

By calculating the average total assets over the evaluation period, this method provides a more accurate and comprehensive assessment of the company's consistent efficiency in deploying assets for profit generation, avoiding distortions from short-term fluctuations.

Let us understand this with a practical example of ABC Company Ltd.

ROA calculation for both the years would be as follows:

Year 1: ROA = Net Income / Average Total Assets

= 80,000 / ((4,75,000 + 5,25,000)/2) = 80,000 / 5,00,000

= 16.00%

Similarly for Year 2: ROA = Net Income / Average Total Assets

= 1,20,000 / ((5,25,000 + 6,75,000)/2) = 1,20,000 / 6,00,000

= 20.00%

The calculation and interpretation of ROA provide us with information about the company's enhanced efficiency in asset utilization. In the initial year, the company generated a 16.00% return on its 5 lakh Rupees worth of average assets. Subsequently, in the second year, as the company expanded its average asset base to 6,00,000 Rupees. It achieved even higher earnings, with profits rising from Rs. 80,000 to Rs. 1,20,000, elevating the return rate to 20.00%. This signifies improved asset efficiency and the added assets contributing value to the company. However, consider a scenario where profits increased only marginally, from Rs. 80,000 to Rs. 85,000, while other factors remained constant. In this case, the ROA, computed using the above formula, would be 14.17%. This suggests that although profits increased in absolute terms, the assets employed to generate those returns were relatively higher than the previous year, potentially indicating a fall in operational efficiency or a lack of compatibility between the newly added assets and the company's overall operations.

While ROA is undeniably a crucial financial metric and a significant measure of profitability, it is not exempt from limitations. One major challenge lies in its inability to be universally applied across diverse industries due to the inherent differences in asset bases among companies in distinct sectors. For instance, companies operating in the oil and gas industry have asset structures that diverge substantially from those in the retail sector.

Additionally, it is important to know that the assets of the companies are recorded as per the historical cost accounting method. Therefore, the asset value of the companies might be misleading and may show distorted results. Apart from these points, this method jumbles things up by comparing returns to equity investors (net income) with assets funded by both debt and equity investors (total assets). So due to the involvement of debt in the actual scenario, the results might be inaccurate.

In conclusion, ROA is still a helpful tool in analyzing a company’s operational efficiency and financial performance. It helps us understand how well a company is using its assets in the business. However, this is just one of the factors in the Fundamental Analysis of a company. To make a thorough study of the company, one must integrate multiple such factors which have been explained in a simple and fun-filled way in my Fundamental Analysis Course available on my website.

Till then, take care, jay hind, and bye-bye.