ROA Ratio Return on Assets
Hello!
Before this video, you should already understand the words and concepts found in Financial
Statements.
When I say, Financial Statements, I mean the Balance Sheet and the Income Statement.
Alright, so, welcome back again to MBAbullshit.com.
The topic for this video is Return on Assets or ROA which is one of the Profitability Ratios
of Financial Ratio Analysis.
Remember, you can always go back to MBAbullshit.com.
So this video discusses and analyzes the Return of Assets or ROA which is one of my free videos
on Liquidity and Profitability which include these ratios over here.
So, these ratios are pertained through Liquidity, Profitability or Market Value.
So after these you can check on my next videos on MBAbullshit.com on Financial Leverage Ratios
and that video includes all these ratios over here and my other video on Turnover Ratios
which includes these ratios over here at the bottom.
Okay, so let’s get down to it.
Let’s start with a story, let’s say the ABC Company has $1000 in Net Income per year
and $4000 in Assets.
What is the Return on Assets?
Well, very simple.
The ROA or Return on Assets equals $1000 which is the Net Income divided by $4000 which is
the total Assets of the company and if we divide these two numbers we get a figure of
0.25 or 25%.
So now we can say that these companies ROA or Return on Assets are 25%.
What does this mean?
Well, this means that for every $100 has in Assets, it makes $25 in profit per year.
Therefore, a higher ROA is considered as better.
The higher ROA indicates that the company is more efficient in using assets to generate
profit; a lower ROA indicates that the company is less efficient in using assets to generate
profit.
Now this ratio isn’t perfect.
There are still some important flaws or should I say, there are a lot of things which this
ratio does not completely tell us or some things which are wrong.
First of all, a high ROA does not necessarily mean high Cash Flow.
Remember, financial managers prefer Cash Flow instead of Profit.
Profit is more of a concept which is used by accountants.
Nowadays, financial managers prefer to use Cash Flow.
The ROA does not take into consideration the actual Cash Flow of the company it only takes
into consideration - Profit.
So if for example your company might have a high ROA because of the high accrued sales
and not cash sales; and/or it may be paid the cash too far into the future.
Remember the meaning of accrued sales meaning you make a sale and you’re supposedly earn
from that sale but you might not necessarily get the cash from that sale until much later
in the future.
Secondly, a low ROA may just be the result of previous’ years intense profitability
and you’re just taking a breather for this year.
So just because you have a low ROA does not mean that things are bad.
Maybe you grew so quickly in the past three years and your company is just taking a breather
for this year and then next year the growth in sales and the growth in profit might continue
quickly again.
It might be the result of growing quickly in the previous years and then maybe your
ROA is low this year just because your most recent years’ earnings are quite low because
you’re getting a breather.
Remember, when you compute the ROA here, this 1000 here is actually the Net Income of the
most recent year not this year because this year is not yet finished.
So you still do not have the figure for the profit of this year because this year has
not yet ended yet.
Three, Asset Value is based on Book Value not real Market Value.
Remember, in this ratio over here, this figure down here is supposed to be the value of the
company’s assets.
Where do we get this $4000?
It is based on Book Value.
Let’s say, your company has assets in the form of a building, for example, or a car.
The value of this building, if you sell it, might be $1,000,000 but your accountant using
the Rules of the Generally Accepted Accounting Principles and the Rules of Depreciation.
They might value the building wrongly at a price of $2,000,000 even though you can sell
it in the market for only $1,000,000.
Why do they value the $2,000,000?
Well, maybe you bought the building for $3,000,000 and minus depreciation, it is now valued in
the book for only $2,000,000 but the real value, if you were to sell it, might actually
only be $1,000,000.
So the Asset Value in computing ROA is based on the Book Value and not the real Market
Value of your Assets.
How would we analyze the company traditionally using ROA?
First is to compare to the historical ROA of the company.
Your company, your client’s company or a company that you’re thinking of investing
in is to compare the historical ROA of the company.
If the ROA is higher now than last year’s then this indicates better efficiency than
before in using assets to generate profit.
If the ROA is lower now than last year’s then this indicates less efficiency than before
in using assets to generate profit.
Another thing you can do is compare ROA to other similar companies.
If this company’s ROA is higher than the ROA of the other similar companies in similar
industries then it indicates better efficiency than them in using assets to generate profits.
Conversely, if your ROA is lower than theirs, then this indicates less efficiency than them
in using Assets to generate profit.
So there you have it.
The earlier part of the video had my own analyses and the later part of the video had traditional
analyses.
So, I hope you learned something.
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So have a Good Day and Goodbye!
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