In this lesson, we’ll discuss return on assets (ROA). You’ll learn to calculate ROA using net income and total assets. You’ll also discover how to provide an accurate analysis of the calculation.
What Are Return on Assets?
You’re an employee working in the accounting department for JLK Industries, a bottled water company. The company has a new CEO, who called a meeting today to discuss the company’s financial position. He starts by noting that JLK Industries’ net income has remained the same, and that the company poorly utilizes its assets.
‘Overall, our return on assets is low,’ he says. ‘Who can explain this concept?You raise your hand and tell him that return on assets is calculated by taking net income and dividing it by total assets. ‘The results show how well we’ll be able to use our assets to generate net income,’ you explain. He tells you, ‘great job!’ And then asks you to write a report on JLK’s return on assets to present to the rest of the company.
For the remainder of this lesson, we’ll discuss the information you’ll need to include in that report, such as net income and total assets.
Net Income as the Numerator
To calculate return on assets, we divide net income by total assets. So, the formula would be ROA = net income / total assets.Net income, which is the numerator in our ROA equation, is a company’s total revenue minus its expenses, such as business costs, depreciation, interest, and taxes. We use net income because it’s a company’s bottom-line number, meaning it’s the final representation of profitability.
You can find a company’s net income on its income statement.
Total Assets as the Denominator
Assets are things that are owned that have value. They can be current, which means they’ll be used or consumed within one year, or long-term, which means they might take longer than a year to sell or use. Current assets can include cash and inventory, while long-term assets are things like equipment or buildings.The return on assets ratio calls for the denominator to be total assets, which can be found on a company’s balance sheet. To find total assets, you would add current and long-term assets. Now that you have a solid understanding of the formula for ROA, let’s look at an example and learn how to analyze return on assets.
JLK Industries’ net income is $2,000,000, while its total assets are $500,000. Thus, we divide $2,000,000 by $500,000, for an ROA of $4. So, for every dollar JLK Industries invested in assets, it produced $4 of net income.To determine if an ROA of $4 is good or bad, we would need to compare it to a prior period, industry average, or competitor. However, in general, the higher the ROA, the better a company is utilizing its assets to produce income.
Return on assets is calculated by dividing net income by total assets. The result of the calculation tells us how well a business is using its assets to generate net income.
It’s important to compare the ratio to a prior period, industry average or competitor. However, the bigger the ratio, the better a business is using its assets to produce income.