Return on Assets
For a farm, a tractor is considered an asset. The tractor helps ploughing the land making it possible to plant and harvest crops. But the tractor might be old and needing maintenance all the time reducing efficiency. Return on assets indicates how effectively the farm is using the tractor (and other assets that help the core business) to plough the land.
How to use return on assets
- Higher is better
- Above 5% is considered healthy
- Can be very different between industries
- Can be used to compare companies
An investor should always look at:
- The current return on assets
- The long term trend
- How it compares to the industry (the competition)
Why do investors use return on assets in their analysis
Shows the investor how effectively the company is using its resources to generate profits.
Things to be aware of
- Only compare with other companies in the same industry
- If a company has many assets changing over time, it’s better to calculate the average assets instead of the total assets.
How to calculate return on assets
- Return on assets = net income / total assets * 100%
ROA is an important ratio as it will tell you how effectively the company is using its resources to generate profits. Example:
Bob and Kristin both sell ice cream in the summer. They both have an ice cream truck. The truck Bob owes cost him $20.000 and the truck Kristin owes cost her $1500. Over the summer, Bob earned $2000 and Kristin earned $200. To calculate the return on assets:
- Bob: $2000 / $20.000 * 100% = 10%
- Kristin: $200 / $1500 * 100% = 13.3%
This tells you Bob’s company is more valuable but Kristin's company is more efficient. Be aware that total assets can change over time. A transportation business will buy and sell trucks or planes all the time. Before using return on assets as a guideline, you have to know what the exact assets are. For a company that has many assets changing over time, it’s better to calculate the average assets instead of the total assets.
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