Stakeholders use financial ratios to analyze various aspects of a company’s operations. Usually, this analysis can also occur through the financial statements. However, they do not provide the same level of comparability that comes with financial ratios. On top of that, these ratios are also easier to understand than the information provided in the financial statements. Stakeholders can choose between various types of financial ratios.
Companies use various profitability ratios to determine how they performed during a period. However, they may have more data to analyze that aspect. For stakeholders, however, these ratios can be highly crucial. With profitability ratios, stakeholders get better insights into a company’s financial performance. In the absence of these ratios, they must rely on the profits reported in the income statement.
Among the profitability ratios, stakeholders have various options. Some of these are straightforward and provide analysis of revenue generations. However, some may also be complex and look at how efficiently and effectively that process occurs. Within those ratios, most stakeholders prefer the return on assets.
What is Return on Assets (ROA)?
Return on assets refers to a financial ratio that determines how much income a company generates. However, it does not look at that income independently. Instead, it indicates how companies make profits relative to the assets used. In other words, returns on assets measure a company’s efficiency in the use of its assets to generate profits. It is one of the most prominent profitability ratios among investors.
Return on assets allows stakeholders to understand how a company uses its resources. It establishes how many total assets a company possesses in its balance sheet. Subsequently, it considers the returns the company generates by using those assets. Companies that use those resources efficiently will have a higher return on assets. In contrast, companies with a lower ROA are inefficient in using resources to generate profits.
Investors consider the return on assets more relevant to their investing decisions. Usually, they want to establish the returns they can get for their limited resources. Therefore, they consider the return on assets to help with those decisions. This ratio helps determine whether a company uses more or lower resources to provide earnings. Usually, they prefer a company with a higher return on assets ratio.
Return on assets measures the percentage of net profits relative to total assets. This ratio has several variants that consider those profits in several cases. For example, stakeholders may only measure the returns on fixed or average assets. Regardless of the variation, the underlying principle for the ratio will remain the same. In all cases, it establishes a company’s efficiency in using resources. However, those resources may differ in each scenario.
Return on assets is a profitability ratio considered crucial for companies and stakeholders. For companies, it helps determine how to use resources efficiently to boost profits. Consequently, they may consider various tips to increase the return on assets. For investors, in contrast, it shows how much returns they can get. However, it measures those returns relative to the invested amounts.
How to Calculate Return on Assets?
As mentioned, stakeholders may use various return on assets variations to calculate the ratio. Usually, it involves dividing the net profits that companies generate by their total assets.
Some stakeholders may also use fixed assets only for that calculation. However, that does not fall under return on assets. Instead, it becomes a return on fixed assets. In both cases, the underlying interpretation remains the same.
Nonetheless, the most straightforward return on assets formula is as below.
Return on assets = Net income / Total assets
Companies obtain the net income from the income statement. The total assets, in contrast, come from the balance sheet. Usually, this includes the end-of-period assets. Therefore, this formula can also come in the following form.
Return on assets = Net income / End of period assets
However, the opening and closing assets may differ significantly for companies in some cases. In those cases, using the end-of-period assets may not be reasonable. Therefore, stakeholders may substitute that part of the ratio with average assets. Consequently, the formula for return on assets will change as follows.
Return on assets = Net income / Average assets
In the above formula, the average assets come from the balance sheet. It involves adding the opening and closing total assets. After that, it includes dividing those assets by two to calculate the average assets. For each formula, the resultant return on assets will differ. However, stakeholders must use the same calculation for different companies for the best comparisons.
How to increase Return on Asset?
The above formulas for return on assets provide details of the steps to increase it. Two factors contribute to this ratio, namely net income and total assets. For companies, it is crucial to understand how to improve the return on assets to attract investors. Therefore, they must impact those two factors to obtain a satisfactory result.
However, increasing the return on assets may be more challenging in practice. Several factors impact how companies can generate more profits for their available resources. Nonetheless, it is not impossible to increase the return on assets. Companies can do so by considering five practical tips, as listed below.
The most obvious answer to increasing return on assets is to increase sales. The more revenues a company generates, the higher its profits will be. These profits play a crucial role in the returns investors get. Higher sales will also imply a company is using its resources to their full potential. This way, it can increase the return on assets without impacting resources.
Another factor that plays a crucial role in improving profits is expenses. The lower these expenses are, the more income a company will generate. As mentioned, this income plays a critical role in determining the return on assets. When companies decrease their expenses, they can achieve a similar result as increasing sales. This way, they don’t have to change their total assets to increase their return on assets.
Some companies may have achieved a stable operating capacity. For them, increasing sales or decreasing expenses may not be an option. Nonetheless, they can still impact profits by increasing their margins. These margins will achieve a similar result as increasing sales. However, the company doesn’t need to increase sale units. Instead, they can achieve higher revenues through higher prices and margins.
Decrease asset costs
Assets costs play a crucial role in determining the return on assets. The higher these costs are, the lower return companies can generate on those assets. Therefore, companies can impact the ratio by focusing on those costs. It may involve obtaining inexpensive resources. However, it must not affect the quality of their products or services. Similarly, companies can dispose of assets they don’t use. This way, their total assets in the balance sheet will decrease.
Improve operations and processes
As mentioned, the return on assets measures a company’s operating efficiency. It measures how efficiently a company uses its resources to generate profits. If companies focus on those operations and processes, they can increase their return on assets. By doing so, they can achieve more sales with the same resources they had before. Consequently, it can increase the return on assets.
Stakeholders use profitability ratios to determine the returns they can get from a company. One of these includes the returns on assets. Essentially, this ratio calculates how efficiently a company uses its resources to profit. Companies can also use this ratio to determine how to attract more investors. Consequently, they can use various practical tips to improve the return on assets, as mentioned above.