Return on assets or ROA measures the percentage rate of return a business gets on its assets. It is calculated by dividing the operating income by the total assets of the business.
Formula for Return on Assets ROA
- Operating income is shown in the income statement. It is sometimes referred to as earnings before interest and tax (EBIT) or profit before interest and tax (PBIT).
- Assets is found in the balance sheet and includes long term assets and current assets. If available, it is better to use the average of the beginning and ending assets.
How to Calculate Rate of Return on Assets
|Cost of goods sold||176,000|
|Income before tax||44,000|
|Income tax expense||9,000|
|Long term assets||390,000|
|Total liabilities and equity||540,000|
In the example above the earnings before interest and tax is 64,000. The total assets are 540,000. The ROA return on assets is given by using the formula as follows:
Return on assets = Operating income / Assets Return on assets = 64,000 / 540,000 Return on assets = 11.85%
The return on assets is considered to be a fundamental financial ratio for a business. It measures the ability of a business to use its money to generate profits.
In this definition of return on assets interest is specifically excluded from the calculation by the use of operating income instead of net income. The amount of interest paid depends on the amount of debt and therefore the capital structure of the business, if interest was included it would distort the ROA calculation and make it impossible to make comparisons with another business funded in a different manner. Of course depending on the comparison required, net income could alternatively be used instead of operating income, in which case the return would take into account the effect of capital structure.
Useful tips for Using the Return on Assets (ROA)
- The ROA will vary from industry to industry. To make comparisons you need to use an industry average ROA for a comparable business operating in your sector.
- The ROA will need to be higher than the return available if the same amount of money was invested in a minimal risk deposit with a bank.
- ROA should always be higher than the rate at which the business borrows as an increase in borrowing leads to an increase in assets which in turn should give a higher return if the ROA is at the correct level.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.