Replacement Cost Approach Advantages and Disadvantages
In the previous article, we have already witnessed what replacement cost theory is and how it can be used to value sporting franchises. We now know the theoretical aspects of this type of valuation. We also know that the replacement cost approach is not used very widely when it comes to the valuation of sports […]
The Role of Commercial Banks In Liquidity Management
Due to increasing globalization in the world economy, a lot of multinational corporations today have their businesses spread out across several geographies. This creates several management problems for multinational companies. Not only do they have to struggle with the complexity of managing personnel and operations in many countries but they also have to ensure proper […]
Commonly Used Terms in Derivative Market
The derivative market can seem like a world unto itself. The market is so large and so different from the other markets that it has its own language. A new person trying to trade derivatives may not even understand the information that is being offered to them. It is therefore necessary to understand the vocabulary […]
Sustainable Growth Rate: Concept
We have studied the various discounted cash flow valuation models in this module. These different models need to be applied in different situations. We have studied these situations as well. However, regardless of which model is being applied, one thing remains constant. In the end, the growth rate of the company plateaus down at a […]
The Need for Derivatives
In the previous article, we discussed as to how derivatives contracts can be dangerous and can pose a systemic risk. Then the question arises as to why are derivates needed at all? If they are dangerous financial instruments, that can pose a risk to the safety of the entire financial universe, then why is it […]
Another metric that is widely used by investors to gauge the profitability of a company is Return on Assets (ROA). More about this very important ratio has been stated in this article.
Return on Assets = Earnings / Asset Base
The Return on Assets (ROA) ratio shows the relationship between earnings and asset base of the company. The higher the ratio, the better it is. This is because a higher ratio would indicate that the company can produce relatively higher earnings in comparison to its asset base i.e. more capital efficiency.
The ROA ratio assumes that the assets have been valued fairly on the books. However, in real life, it is a known fact that companies keep over and/or under valuing their assets to reduce taxation. This may affect the ROA adversely and reduce its usability as a profitability metric.
The Return on Assets ratio assumes that the company is using all its assets to run the day to day operations. This assumption is likely to be proved incorrect. A lot of companies hold significant cash on their balance sheet. The most valuable company in the world Apple Inc is one such example. Also many other companies hold a lot of impaired and obsolete assets which they plan to sell in the near future. This brings down the Return On Assets (ROA) ratio.
Return on assets compares the earnings that a company has generated to its asset base. The asset base could be financed by equity or by debt but it will not make a difference. Return on Assets is therefore independent of leverage.
Return on Assets is very sensitive to the stage of growth that a company is currently experiencing. In the introduction and growth stage, companies invest a lot of money to create asset bases. They may not use the asset base immediately and the benefits may be realized years later. Hence, two companies in the same industry, but at different stages of growth, will have very different Return On Assets.
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