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Return on assets

Return on assets is defined as net income divided by average total assets for the period.

Expanded Definition

Return on assets is a measure of the efficiency of a company. How well does the company use its assets to generate profit?

<math>ROA = \frac{net\ income}{\frac{Total\ assets\ beginning\ of\ period + Total\ assets\ end\ of\ period}{2}}</math>

However, it can be broken down further to get a better look at what is happening in the company.

<math>ROA = \frac{Net\ income}{Total\ sales} * \frac{Total\ sales}{Avg\ total\ assets} = Net\ margin * Asset\ turnover</math>

What this allows you to do is to discover strengths and weaknesses at the company. If net margin is high, but asset turnover is low, ROA will be low. This is especially good to see when comparing the company against its peers. If two companies have the same net margin but different ROAs, then the difference must be that one company is using its assets more efficiently than the other to generate sales.

Contrariwise, if a company wishes to improve its ROA and it finds that its asset turnover is close to industry norms while its net margin is lower, then net margin should be what it works on.

One can also check this component analysis to see if a company's announcement that it is cutting expenses actually makes sense. For instance, if the company's net margin is at or even above industry norms, but its ROA is below, the company would do better to improve asset turnover, maybe by upgrading some of its assets (such as manufacturing plants) to more modern, efficient ones.

An example

Let's look at Nike's ROA for 2003 - 2005:

Year ROA Profit Margin Asset Turnover
2003 7.1% 4.4% 1.61
2004 12.8% 7.7% 1.66
2005 14.5% 8.8% 1.65

You can see from this that company didn't really improve how much revenue its assets were generating (on a dollar-for-dollar basis), but that they improved their profit margin, thereby becoming more efficient overall.

An alternate definition

Instead of using net income, some analysts calculate it using EBIT * (1 - tax rate). (EBIT = earnings before interest and taxes, a.k.a. operating income.) The tax rate is often standardized, either overall or for an industry.

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