Return on Assets ROA, What, How it is calculated?

Return on Assets ROA, What, How it is calculated?

Return of Assets states the condition of the company that how the company is performing with respect to its assets.ROA gives the management of the company or investor that how the company utilizes its assets to give the expected returns.ROA is shown in percentage.

In order to utilize the assets most of the company try to squeeze their limited resources and try to maximize the profit.

For example, a company tries to produce its product beyond its rated capacity. Like running the plant more than 100% (To the maximum level of design)

What is Asset?

Asset = Equity + Liability

Assets are of two types.

1.       Current Asset: Payment received in a year

2.      Noncurrent Asset: Payment is to be received after 1 year.

Liabilities are of two types.

1.       Current liabilities : Payment is to be done within one year

2.      Noncurrent liabilities : Payment is to be done after 1 year

Return on Assets means how the company is utilizing its asset to earn more profit. So it means the company which has more ROA than its competitor then that company will be more better than the others.

ROA = Profit / Asset

We can understand the asset from the balance sheet but the question is what type of profit is to be considered here?

Whether it is to be considered as PBIT or PBT or PAT? It always creates confusion

Explanation:

When we calculate ROE we consider total equity.

As ROE = PAT/Total Equity

Here why we are considering PAT in ROE because the priority of the payment is

1.       Interest

2.      Tax

3.      Equity Returns

 The third number is equity return hence here we have to consider PAT here.

Normally many analysts use the formula for ROA as

1.       ROA = PAT/Total Asset

But ideally, it should be

2.      ROA = PAT + Interest (1-Tax %)/Total Asset

PAT is considered in ROE so interest should not be considered in ROA and we are including liabilities also as a basic definition of the asset mentioned above.

The third formula used by the analyst is

3.      ROA = PBIT/Total Asset

 

4.      ROA = PAT/Total Average Asset.

As per my opinion the 2 &3 number are better.

No 4 formula is used whenever there is any change of asset value in the year this is just by taking the start asset value at the beginning of the year and at the end of the year and divide it by 2. For example, if a company sells it some nonperforming assets in the year then the asset value will get changed.

However whichever formula is used stick to one formula for comparison of companies.

ROA for the different sectors is varying a lot. It depends on the type of company. ROA for the banks, financial institutes, telecoms, the software is higher than the capital intensive industry chemical industry, construction Industry.

Let us understand by example:

Suppose company A has established with a capital of 4 crores. With the following details.

Equity Capital	300L
Liabilities @ 10% interest rate	50L

Financial Statement

EBIT (Earnings before Interest and Tax)(Operating profit)	100,00,000 (100L)
Interest on Debt (-)	30,00,000 (30L)
PBT Profit before Tax	70,00,000 (70L)
Tax @ 30% (-)	21,00,000 (21L)
PAT (Profit after tax) (Net profit)	49,00,000 (49L)

 

ROA = PAT/Total Asset    

         = 49L/350L

         = 14%

ROA = PAT + Interest (1-Trate)/Total Asset

        = 49L+30L (1-0.30)/350L

         =49L+21L/350L

        = 20%

ROA = PBIT/Total Asset

        = 100L/350L

        = 28.57%.

From the above calculation we will observe that there is a lot of difference while using different formulas. So if you want to carry out the comparison between the companies one should apply same formula for all the companies otherwise result will be absurd and it will misguide you.

Let us understand the comparison of two companies.

(Same sector company)	Company-A	Company-B
Equity capital	300L	900 L
Liabilities @ 10% interest rate	50L	500L
EBIT (Earnings before Interest and Tax)(Operating profit)	100L	800L
Interest Debt (-)	5L	50L
PBT Profit before Tax	95L	750L
Tax @ 30%	28.5L	225L
PAT	66.5	525L

 

ROA (company-1):

ROA = PBIT/Total Asset

=100L/350L

= 28.57%.

ROA (company-2)

ROA = PBIT/Total Asset

         =800L/1400

        = 57.14%

By comparing the above example it clearly shows that company-2 is performing better than company-1. It means it is efficiently using its asset to generate profit.

Important points of ROA.

·         Company having better ROA indicates that it is efficiently using the Assets But it is not the only ratio to be considered while choosing the stock for investment. Other financial ratios are also to be compared to get the overall picture.

·         ROA can be increased by:

1.       Increasing PBIT

a.      Better pricing

b.      Economics of scale (High volume low margin)

c.       Lowering cost by better efficiency and productivity.

2.      Decrease Assets

a.      Reducing accounts receivable (reduction of credit time)

b.      Better inventory turnover

c.       Higher asset utilization.

d.      Leasing instead of buying (Optional)

e.      Divesting lower margin businesses/assets.

Limitations of ROA:

ROA cannot be compared for different sector companies as different sectors have different ROA. This means you cannot compare the ROA of Software Company with the petrochemical Industry.

 Live Example: AS on today i.e. 14 Sep 2020 15:21 hrs.

KEY FINANCIAL RATIOS OF INFOSYS (in Rs. Cr.)	MAR 20	MAR 19	MAR 18	MAR 17	MAR 16
PER SHARE RATIOS
PROFITABILITY RATIOS
Return on Capital Employed (%)	31.28	31.38	31.00	27.80	20.75
Return on Assets (%)	19.17	18.62	21.29	17.29	17.45
Total Debt/Equity (X)	0.00	0.00	0.00	0.00	0.00
Asset Turnover Ratio (%)	97.53	92.62	81.63	74.21	74.22

 

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Return Ratios	MAR 2020	MAR 2019	MAR 2018	MAR 2017	MAR 2016
Return on Networth / Equity (%)	38	35	30	30	34
ROCE (%)	46	45	39	39	33
Return On Assets (%)	27	27	24	25	27

 

From the above example, TCS ROA is 27% and its peer company Infosys is having ROA 19.17% as of March 2020. That means TCS is utilizing assets better way than Infosys.

But this is not the only ratio to be compared for choosing the stock for investment other financial ratios are also to be considered.