Return on assets is a measure comparing a company’s revenues with the value of its underlying assets. It is commonly used as a way of comparing how well rival firms in an industry are performing, given their size. It can also indicate how much of a firm’s worth is tied up in capital, which in turn can suggest how much investment it may need in order to succeed.
The main idea of the return on assets ratio is that it is calculated as revenue over assets. While some uses of the ratio simply use the annual net income as the revenue figure, others add on interest costs and then deduct interest tax savings. Doing this effectively takes the costs of some assets, such as the interest paid on cash which has been borrowed, out of the equation.
The assets figure is an average of total assets. This is taken from the assets figures listed on a company’s balance sheet and includes cash, investments, money owed to a company, and the cost of buildings, equipment and stock. In many cases the average total assets figures is taken from across both the current and previous year. There can be a risk of the assets figure being misleading, since in this context it is usual to list financial assets such as stocks by their "carrying value." This is the value they were bought for and may not accurately reflect the price they would fetch if they had to be sold now.
Calculating the return on assets can serve two main purposes. First, it can give potential investors an idea of how well a company performs with the assets it has. This may suggest that a small company may do a better job using an investment than a larger company. Another use is for the company itself to analyze how well it is likely to use an investment. If the company’s existing return on asset figure is considerably lower than the interest rate it would have to pay to borrow money, it may be that borrowing money would be inefficient until the company undergoes some fundamental changes.
It’s not usually very informative to compare the return on assets of companies from vastly different industries. This is because the nature of the industry itself may play as important or even more important a role in return on assets as the performance of the individual company. For example, a manufacturing industry may require considerably more capital such as machinery than a service industry, which can distort the ROA figures. There are also some industries which have legal restrictions on their asset levels such as a financial company being required to hold a certain proportion of their liabilities in cash.