Helping your clients understand the health and efficiency of their businesses is crucial. One of the most valuable tools for this purpose is the return on assets (ROA). This metric measures how effectively a company uses its assets to generate net earnings.
In this article, Wealth Professional Canada will discuss everything you need to know about ROA, how it is calculated, and how you can use it to benefit your clients.
Return on assets is a profitability ratio that reflects how efficiently a company uses its total assets to generate net earnings. Expressed as a percentage, ROA answers a fundamental question: How much is the company earning in net income for each dollar of assets owned?
For financial advisors, understanding this ratio is necessary because it reveals whether your clients are making the most of their resources. ROA is especially useful because it allows for comparisons between companies of similar size and industry. It also helps track a single company’s performance over time.
If your clients want to know if their business is becoming more efficient or if they are lagging behind competitors, ROA can provide a clear answer:
Evaluating ROA is part of conducting fundamental analysis. It is often used alongside other ratios to compare companies within the same industry and to track performance over time.
Calculating ROA is straightforward, but it is important to use the correct figures. The formula is:
Net income is the profit after taxes, found at the bottom of the income statement. Average total assets is calculated by adding the beginning and ending total assets for a period and dividing them by two. This figure comes from the balance sheet.
For example, if your client’s company had a net income of $20,000 and average total assets of $300,000, the ROA would be 6.7 percent. This percentage tells you how much profit is generated for each dollar of assets.
It is a good idea to calculate ROA at least once a year, using annual financial statements. For more frequent monitoring, quarterly calculations can provide early warnings of changes in efficiency or profitability.
Use the calculator at the top of this article for quick calculations of return on assets!
Yes, ROA can be negative if a company has a net loss. A negative ROA indicates that the company is not generating enough profit to cover its asset base. This can be a red flag but remember to check thoroughly to be certain.
There is no universal ideal ROA, but there are some general guidelines. In most industries, an ROA below five percent is considered low, while an ROA above 20 percent is considered excellent. However, these benchmarks can vary depending on the sector.
For example, manufacturers often have lower ROA because they require more assets, such as machinery and facilities, to operate. In contrast, technology or service companies might have higher ROA because they rely more on intangible assets like intellectual property.
As a financial advisor, it is important to compare your clients’ ROA with that of similar companies in the same industry. This approach provides a more accurate picture of performance and helps avoid misleading conclusions.
ROA is more than just a number. It can be a window into how well your clients are managing their resources. A higher ROA can mean that the company is using its assets efficiently to generate profits. On the other hand, a lower ROA might indicate that assets are underutilized. It can also mean that management is not allocating resources effectively.
When you track this metric, you can help your clients identify strengths and weaknesses in their operations.
If ROA is consistently high, it suggests that the company is operating near full capacity and making the most of its investments.
If ROA is low or declining, it might be time to review asset purchases, operational efficiency, or even management strategies.
ROA is most useful for companies with significant assets, such as manufacturers or retailers. For service-based businesses with fewer tangible assets, ROA can still provide insights but might need to be interpreted alongside other metrics.
ROA increases when a company becomes more efficient at using its assets to make profits. This can happen if:
If your clients’ ROA is rising over time, it means the company is improving its ability to generate profit from its assets. This is a positive sign of better performance and efficiency.
To get the most out of ROA, you might want to follow these best practices:
While ROA is a valuable metric, there are some concerns to watch out for:
When you avoid these pitfalls, you can provide your clients with more accurate and actionable advice.
One of the most powerful ways to use ROA is to track it over several years. This time analysis allows you to see whether your clients’ company is improving its ability to generate profits from its assets.
If ROA is rising, it suggests that the company is becoming more efficient and making better use of its resources. If ROA is falling, it might indicate that the company has acquired too many assets or is not using them effectively.
Competitive analysis is another valuable use of ROA. When you compare your clients’ ROA with that of similar companies, you can determine whether their financial performance is better, similar, or lower than competitors.
For example, if your client’s ROA is five percent while the industry average is 10 percent it is worth investigating the reasons for the gap. Are operating expenses or the cost of goods sold too high? Are operating margins too low? Are assets underutilized? These questions can guide your advice and help your clients take corrective action.
ROA is just one of several profitability ratios that financial advisors use to assess a company’s performance. Other metrics include:
The main difference is that ROA considers all assets, not just equity. This perspective makes ROA especially useful for evaluating companies with significant debt or large asset bases.
Watch this video to better understand how ROA compares to ROE:
For other financial metrics and other wealth-related terms, feel free to visit our Glossary page!
Return on assets is a useful measure for assessing business efficiency and profitability. If you have the knowledge to calculate and analyze ROA, you can help investors improve their operations and achieve their financial goals. Interpreting it is also equally important.
Remember, you should use ROA in context and compare it with industry peers. This way, you can avoid making assumptions that can lead to incorrect advice. Always combine it with other financial metrics for a full picture of performance. Lastly, aside from ROA and related measures, use industry benchmarks when conducting fundamental analysis for better results.
Check out our Investor Resources page to see more about return on assets.
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