Return on Assets Ratio
By Colin Nicholson
In the April newsletter we looked at the return on equity ratio. That is one way to measure how a company is performing compared with previously and compared with other similar companies. In that ratio, we were measuring the rate of return that the management of the company were achieving on the equity, or funds that the shareholders notionally owned in the company.
However, there is more than one way to assess return. Another ratio that is commonly used by analysts is the return on assets ratio. As the name of this ratio suggests, it measures what return is being achieved on the assets that are possessed by the company and therefore notionally owned by the shareholders.
Some people have trouble understanding the difference between equity and assets. A good way to grasp the difference is to go back to the balance sheet. A balance sheet in its most basic form is composed of three components:
- Assets what the company owns
- Liabilities what the company owes
- Equity what the shareholders own
If we deduct what the company owes (liabilities) from what the company owns (assets), we get the third component equity (or shareholders' funds). Equity is what the shareholders own. If all debt is repaid from assets, the balance is what the shareholders own, or their equity.
Since a company is financed partly from selling equity (shares) and partly by borrowing money (debt), another way of looking at what the shareholders own is the total of assets. This assumes that the business is a going concern and that over time its profits will enable it to repay debt.
In very simple terms, the return on assets ratio is the profit made by the company as a percentage of the assets of the company. So, if the company's profit for the last year was $100 million and the assets owned by the business were $800 million, the return on assets was 100 800 100 = 12.5%.
Clearly, the higher this percentage is the better. More importantly, we will want to see the return increasing over time.
Analysts will use EBLIT as the profit figure in this ratio, which can be stated formally as:
Return on Assets (ROA) = EBLIT* Total Assets** 100
* EBLIT stands for Earnings Before Leasing, Interest and Tax.
** Strictly, Total Assets less cash and interest bearing investments.
Colin Nicholson's books: Building Wealth in the Stock Market and The Psychology of Investing may be purchased from Colin's website www.bwts.com.au and good bookstores). Contact Colin at firstname.lastname@example.org or through his web site where you may join the list to receive his free email newsletter.