Return on assets (ROA) is a financial ratio that shows the percentage of profit a company earns in

relation to its overall resources. It is commonly defined as net income divided by total assets. Net
income is derived from the income statement of the company and is the profit after taxes. The assets
are read from the balance sheet and include cash and cash-equivalent items such as receivables,
inventories, land, capital equipment as depreciated, and the value of intellectual property such as
patents. Companies that have been acquired may also have a category called "good will" representing
the extra money paid for the company over and above its actual book value at the time of acquisition.
Because assets will tend to have swings over time, an average of assets over the period to be measured
should be used. Thus the ROA for a quarter should be based on net income for the quarter divided by
average assets in that quarter. ROA is a ratio but usually presented as a percentage.

ROA answers the question: "What can you do with the assets that you have available?" The higher the
ROA, the better the management. But this measure is best applied in comparing companies with the
same level of capitalization. The more capital-intensive a business is, the more difficult it will be to
achieve a high ROA. A major equipment manufacturer, for instance, will require very substantial assets
simply to do what it does; the same will be true for a power plant or a pipeline. A fashion designer, an ad
agency, a software firm, or a publisher may require only minimal capital equipment and will thus
produce a high ROA. To compare Microsoft with General Motors on the basis of ROA is to compare
apples to oranges. The industry average ROA for software companies in mid-2006 was 13.1 and
Microsoft's own stood at 20.1. The industry ROA for autos was 1.1 and GM's was a negative 1.8.

The difference between a highly capitalized business and one running largely on intellectual property or
creative assets is that, in the case of failure, the capital-intensive company will still have major assets
that can be turned into real money whereas a concept-based enterprise will fail when its art is no longer
favored; it will leave a few computers and furniture behind. Therefore ROA is used by investors as one of
several ways of measuring a company within an industry, comparing it with others playing by the same
rules.

USES FOR ROA

Unlike other profitability ratios, such as return on equity (ROE), ROA measurements include all of a
business's assets-;those which arise out of liabilities to creditors as well capital paid in by investors. Total
assets are used rather than net assets. Thus, for instance, the cash holdings of a company have been
borrowed and are thus balanced by a liability. Similarly, the company's receivables are definitely an
asset but are balanced by its payables, a liability. For this reason, ROA is usually of less interest to
shareholders than some other financial ratios; stockholders are more interested in return on their input.
But the inclusion of all assets, whether derived from debt or equity, is of more interest to management
which wants to assess the use of all money put to work.
ROA is used internally by companies to track asset-use over time, to monitor the company's
performance in light of industry performance, and to look at different operations or divisions by
comparing them one to the other. For this to be accomplished effectively, however, accounting systems
must be in place to allocate assets accurately to different operations. ROA can signal both effective use
of assets as well as under-capitalization. If the ROA begins to grow in relation to the industry's as a
whole, and management cannot pinpoint the unique efficiencies that produce the profitability, the
favorable signal may be negative: investment in new equipment may be overdue.

Another common internal use for ROA involves evaluating the benefits of investing in a new system
versus expanding a current operation. The best choice will ideally increase productivity and income as
well as reduce asset costs, resulting in an improved ROA ratio. For example, say that a small
manufacturing company with a current sales volume of $50,000, average assets of $30,000, and a net
profit of $6,000 (giving it an ROA of $6,000 / $30,000 or 20 percent) must decide whether to improve its
current inventory management system or install a new one. Expanding the current system would allow
an increase in sales volume to $65,000 and in net profit to $7,800, but would also increase average
assets to $39,000. Although sales would increase, the ROA of this option would be the same-;20
percent. On the other hand, installing a new system would increase sales to $70,000 and net profit to
$12,250. Because the new system would allow the company to manage its inventory more efficiently,
the average assets would increase only to $35,000. As a result, the ROA for this option would increase to
35 percent, meaning that the company should choose to install the new system.

What is Return on Assets - ROA

Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA
gives a manager, investor, or analyst an idea as to how efficient a company's management is at using its
assets to generate earnings. Return on assets is displayed as a percentage and its calculated as:

ROA = Net Income / Total Assets

Note: Some investors add interest expense back into net income when performing this calculation
because they'd like to use operating returns before cost of borrowing.

Sometimes, the ROA is referred to as "return on investment".

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Return On Assets (ROA)

BREAKING DOWN Return on Assets - ROA

In basic terms, ROA tells you what earnings were generated from invested capital (assets). ROA for
public companies can vary substantially and will be highly dependent on the industry. This is why when
using ROA as a comparative measure, it is best to compare it against a company's previous ROA
numbers or against a similar company's ROA.

Remember that a company's total assets is the sum of its total liabilities and shareholder's equity. Both
of these types of financing are used to fund the operations of the company. Since a company's assets
are either funded by debt or equity, some analysts and investors disregard the cost of acquiring the
asset by adding back interest expense in the formula for ROA. In other words, the impact of taking more
debt is negated by adding back the cost of borrowing to the net income, and using the average assets in
a given period as the denominator. Interest expense is added because the net income amount on the
income statement excludes interest expense. An analyst that chooses to ignore the cost of debt will use
this formula:

ROA = (Net Income + Interest Expense) / Average Total Assets

The ROA figure gives investors an idea of how effective the company is in converting the money it
invests into net income. The higher the ROA number, the better, because the company is earning more
money on less investment. Let's evaluate the ROA for three companies in the retail industry - Macy's,
J.C. Penney, and Sears. The data in the table is for the fiscal year ended January 28, 2017.
Company Net Income Total Assets ROA

Macy's $611 million $19.85 billion 3.08%

J.C. Penney $1 million $9.31 billion 0.011%

Sears $ –2.22 billion $9.36 billion –23.72%

Due to the increasing popularity of e-commerce, brick-and-mortar retail companies have taken a hit in
the level of profits they generate using their available assets. Every dollar that Macy's invested in assets
in 2016 generated 3 cents of net income. On the other hand, every dollar used to purchase assets in
Sears translated into a 24-cent loss for the company. Sears' negative ROA coupled with its high total
debt of $13.19 billion means that the company is receiving little income, even though its investing a high
amount of capital into its operations. Given that the company is not generating any positive income per
invested capital, this investment might not be a good option for investors.

It appears that Macy's is better at converting its investment into profits, and J.C.Penney may need to re-
evaluate its business strategy as it's ROA is very low. When you really think about it, management's most
important job is to make wise choices in allocating its resources. Anybody can make a profit by throwing
a ton of money at a problem, but very few managers excel at making large profits with little investment.

ROA is most useful for comparing companies in the same industry, as different industries use assets
differently. For example, the ROA for service-oriented firms, such as banks, will be significantly higher
than the ROA for capital intensive companies, such as construction or utility companies.

What is Return on Equity (ROE)

Return on equity (ROE) is a measure of financial performance calculated by dividing net income by
shareholders' equity. Because shareholders' equity is equal to a company’s assets minus its debt, ROE
could be thought of as the return on net assets.

ROE is expressed as a percentage and can be calculated for any company if net income and equity are
both positive numbers. Net income is calculated before dividends paid to common shareholders and
after dividends to preferred shareholders and interest to lenders.
Relatively high or low ROE ratios will vary significantly from one industry group or sector to another.
When used to evaluate one company to another similar company the comparison will be more
meaningful. Even within the same industry group, comparing the ROE of a company that pays a large
dividend with a firm that doesn’t can also be misleading.

Return On Equity (ROE)

BREAKING DOWN Return on Equity (ROE)

Net income over the last full fiscal year, or trailing twelve months, is found on the income statement: a
sum of financial activity over that period. Shareholders' equity comes from the balance sheet: a running
balance of a company’s entire history of changes in assets and liabilities. It is considered best practice to
calculate ROE based on average equity over the period because of this mismatch between the two
financial statements.

Average shareholder equity is calculated by adding equity at the beginning of the period to equity at the
end of the period and dividing by two. Investors can use quarterly balance sheets to calculate an even
more accurate equity average.

Imagine a company with an annual income of $1,800,000 and average shareholders' equity of
$12,000,000. This company’s ROE would be 15%.

ROE = $1,800,000/$12,000,000 = 15%

It is not a good practice to compare the ROE of one company to another if they are very dissimilar,
however, it is a common shortcut for investors to consider a ROE near the long-term average of the S&P
500 (14%) as an acceptable ratio and anything less than 10% as poor.

Using Return on Equity to Estimate the Growth Rate

Although there may be some challenges, ROE can be a good starting place for developing future
estimates of a stock’s growth rate and the growth rate of its dividends. These two calculations are
functions of each other and can be used to make an easier comparison between similar companies.

To estimate a company’s future growth rate, multiply ROE by the company’s retention ratio. The
retention ratio is the percentage of net income that is “retained” or reinvested by the company to fund
future growth.

Assume that there are two companies with an identical ROE and net income, but different retention
ratios. The first company, DivCo, has an ROE of 15% and returns 30% of its net income to shareholders in
a dividend, which means DivCo retains 70% of its net income. The second company, GrowthCo, also has
an ROE of 15% but returns only 10% of its net income to shareholders for a retention ratio of 90%.

DivCo Growth Rate (10.5%) = ROE (15%) X Retention Ratio (70%)

GrowthCo Growth Rate (13.5%) = ROE (15%) X Retention Ratio (90%)

This analysis is referred to as the sustainable growth model. Investors can use this model to make
estimates about the future and to identify stocks that may be risky because they are running ahead of
their sustainable growth ability. A stock that is growing slower than its sustainable rate could be
undervalued, or the market may be discounting risky signs from the company. In either case, a growth
rate that is far above or below the sustainable rate warrants additional investigation.
This comparison seems to make GrowthCo look more attractive than DivCo, but it ignores the
advantages of a higher dividend rate that may be favored by some investors. We can modify the
calculation to make an estimate of the stock’s dividend growth rate which may be more important to
income investors.

The dividend growth rate can be estimated by multiplying ROE by the payout ratio. The payout ratio is
the percentage of net income that is returned to common shareholders through dividends. This formula
gives us the sustainable dividend growth rate, which favors DivCo.

DivCo Dividend Growth Rate (4.5%) = ROE (15%) X Payout Ratio (30%)

GrowthCo Dividend Growth Rate (1.5%) = ROE (15%) X Payout Ratio (10%)

A stock that is growing its dividend far above or below the sustainable dividend growth rate may
indicate risks that need to be investigated.

Using Returned on Equity to Compare Stocks

A good or bad ROE will depend on what is normal for a stock’s peers. For example, utilities have large
asset and debt accounts on the balance sheet compared to a relatively small amount of net income. A
normal ROE in the utility sector could be 10% or less. A technology or retail firm with smaller balance
sheet accounts relative to net income may have normal ROE levels of 18% or more.

A good rule of thumb is to target an ROE that is equal to or just above the average for the peer group.
For example, assume a company, TechCo, has maintained a steady ROE of 18% over the last few years
compared to the average of its peers, which was 15%. An investor could conclude that TechCo’s
management is above average at using the company’s assets to create profits.

How Return on Equity Can Identify Problems

It’s reasonable to wonder why an average or slightly above average ROE is good rather than an ROE that
is double, triple, or even higher the average of their peer group. Aren’t stocks with a very high ROE a
better value? Sometimes an extremely high ROE is a good thing if net income is extremely large
compared to equity because a company’s performance is so strong. However, more often an extremely
high ROE is due to a small equity account compared to net income, which indicates risk.

Inconsistent Profits

Imagine a company, LossCo, that has been unprofitable for several years. Each year’s losses are on the
balance sheet in the equity portion as a “retained loss.” The losses are a negative value and reduce
shareholder equity. Assume that LossCo has had a windfall in the most recent year and has returned to
profitability. The denominator in the ROE calculation is now very small after many years of losses which
makes its ROE misleadingly high.

In this case, a very high ROE was helpful because it would have alerted investors that LossCo doesn’t yet
have a consistently profitable track record. An investment in a stock like LossCo would be riskier than
those with stable profit trends and a lower ROE.

Excess Debt

If a company has been borrowing aggressively, it can increase ROE because equity is equal to assets
minus debt. The more debt a company borrows, the lower equity can fall. A common scenario that can
cause this issue occurs when a company borrows large amounts of debt to buy back its own stock. This
can inflate Earnings Per Share (EPS) but it doesn’t affect actual growth rates or performance.

Negative ROE

If a company has negative net income (losses) then ROE is usually not calculated. However, if a company
has negative equity because of a prior period of losses, excessive borrowings, or a long-term pattern of
share buybacks, ROE can become negative because the denominator in the calculation is a negative
number.

If ROE is negative, the most common issue is excessive debt or inconsistent profitability. However, there
are exceptions to that rule for companies that are profitable and have been using cash flow to buy back
their own shares. For many companies, this is an alternative to paying dividends and it can eventually
reduce equity (buybacks are subtracted from equity) enough to turn the calculation negative.

In all cases, negative or extremely high ROE levels should be considered a warning sign worth
investigating. In rare cases, a negative ROE ratio could be due to a cash flow supported share buyback
program and excellent management, but this is the less likely outcome. In any case, a company with a
negative ROE cannot be evaluated against other stocks with positive ROE ratios.

Summary

Return on equity is the ratio of net income (profits) to equity or net assets (assets - liabilities). ROE is
considered a measure of how effectively management is using a company’s assets to create profits.
Sustainable growth rates and dividend growth rates can be estimated using ROE assuming that the ratio
is roughly in line or just above its peer group average. Using ROE to compare stocks can be helpful, but
investors should be careful of comparison between stocks that are very dissimilar or with different
dividend strategies.

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