Objectives of Accounting
Every activity that a business firm does must be done for a reason and accounting is no exception. Accounting helps the company achieve a myriad of objectives. Here is the list of objectives that accounting helps the company to obtain. Permanent Record Any business firm needs a permanent record of the transactions that it indulges […]
The Deepening Insolvency Theory
Timing is everything when it comes to bankruptcy claims. Any company facing the threat of bankruptcy has a duty to ensure that it maximizes the enterprise value. This means that the company, its lenders, and its managing officers have an inherent duty to ensure that one particular group of stakeholders is not benefitting at the […]
What is Bond Valuation and How is it Calculated ?
One of the Most Important Uses of Discounting The present value of a bond is the sum of all the future cash flows that can be derived from it. In this sense, the valuation of bonds really becomes simple, isn’t it? All we need to do is find out the future stream of payments that […]
Shark Repellent Tactics in Investment Banking
The profession of investment banking has evolved over the years. Earlier, they were only used when companies wanted to issue securities and raise capital. Over the years, companies have realized that investment bankers know how to make securities more palatable to the investor community. Hence, they also know how to run the process in reverse, […]
Responsibilities of Pension Fund Regulators
In the previous article, we have already determined why it is important to closely monitor the workings of pension funds and also to regulate them. However, regulation is a broad concept. It encompasses a wide variety of actions that need to be undertaken. In this article, we will have a closer look at various activities […]
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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