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Return on Assets equals net income plus interest expense divided by average assets over a given period

Return on Assets (ROA) measures how profitable a company is relative to its total assets. In turn, it measures how efficiently a company uses its assets. Generally, ROA should be used to compare companies in the same industry. Everything else being equal, a higher ROA is better, as it means that a company is more efficient about using its assets.

Companies use both debt and equity to acquire their assets, and ROA can be used to determine how effectively they are turning their funding into earnings. The crucial difference between ROA and Return on Equity (ROE), the other major profitability ratio, is that the ROA remain relatively unaffected by a company's choice of capital structure -- the choice of using debt versus equity to fund operations.

In the case of the ROA, the influence of taking more debt is negated by adding back interest expense to net income in the numerator, and by using average assets (in a given period), instead of equity in the denominator. However, the choice of capital structure structure can still influence the ratio due to the treatment of interest in calculating taxes -- since a company with a high debt pays less taxes (due to higher interest expense) compared to a company with no debt.

ROA varies from industry to industry. For example: The ROA for service-oriented industries, such as the banking industry, is significantly higher than that of capital-intensive industries such as the construction industry. Its usefulness in comparing one industry with another is limited as the risks and accounting variations of different industries are not captured by the ratio. Moreover, the ratio can only be calculated for companies earning a profit, and therefore would mislead an investor trying to compare two industries with different levels of profitability. For example, an industry, such as the software industry, where a lot of the companies are making a loss and some are earning spectacular profits, can not be compared, on the basis of ROA, to an industry such as utilities, where most companies earn a modest profit.

Example

• Company A earned $5 million in net income and paid $1 million in interest expense. Its assets in the beginning of the year were $10 million, and at the end of the year were $20 million. Therefore, the company's ROA during the year was 40% [($5 million + $1 million)/(($10m + $20m)/2)].

ROA calculations on Wikinvest

There are several ways to calculate Return on Assets. The simplest way to calculate the ratio is to divide net income by total assets. However, this leads to two problems:

• The ratio is influenced by the capital structure as net income is calculated after taking out interest expense.

• Taking the total assets at the end of the fiscal year is conceptually misleading, as the net income was earned using the assets the company owned earlier. For example: If the company had a stock issuance at the end of the fiscal year and increased its cash position, its ROA would be affected by the fact that its assets increased. However, in reality, the company only had the additional assets for a day and those funds were not available during the year.

In order to address these issues, Wikinvest uses the modified version of the formula:

ROA = (Net Income + Interest Expense) ÷ (Average Assets during the period)

The formula addresses the two problems mentioned above by adding back interest expenses, and taking average assets held during a period (instead of total assets at given point in time). Average assets is calculated by taking the average of assets at the beginning of the period and assets at the end of the period.

Return on assets on Wikinvest would disagree with its corresponding entry in Google Finance since Google uses the formula: net income/average assets. Wikinvest disagrees with this treatment for the reasons stated above.

On the other hand, the number would also disagree with that on Yahoo! Finance. This is because Yahoo! attempts to take into consideration the possible tax shield generated by interest expense and add it back to the numerator. Conceptually this is the correct treatment.

However, in practice, it is not possible to figure out the exact value of tax shield with the information available on Yahoo! Finance and on Wikinvest. One of the main reason being that tax shield should be calculated using the marginal tax rate rather than the average tax rate. Yahoo!'s method only leads to an approximation of the tax shield.

Wikinvest chooses to ignore this technicality as it is unlikely to dramatically affect the return on assets on any given company.