How to calculate Return On Assets or ROA?
I will take you through two examples of calculating ROA, and then show you what the next steps
in your financial analysis can be.
ROA or Return On Assets is defined as Net Income divided by Assets.
You find the Net Income number on the income statement or P&L, and the assets number on
the balance sheet.
Let's perform the ROA calculation for two well-known American companies from very different
industries: telecom company Verizon, and retail company Walmart.
Let's start with Verizon.
We need Verizon's Net Income number, so let's take a look at the income statement and take
the most recent full year: 2016.
The Net Income for Verizon in the twelve months of 2016 was $13.6B, which is the numerator
in our ROA equation.
Next is the Assets number on the balance sheet.
Total assets on December 31st, 2016 was $244.2B.
We fill in this number as the denominator in the equation, and can now calculate Verizon's
Return On Assets for 2016 as 5.6%.
We follow the same procedure for Walmart.
We need Walmart's Net Income number, so let's take a look at the income statement.
The Net Income for Walmart in the twelve months of 2016 was $15.1B, which is the numerator
in our ROA equation.
Next is the Assets number on the balance sheet.
Total assets on December 31st, 2016 was $199.6B.
We fill in this number as the denominator in the equation, and can now calculate Walmart's
Return On Assets for 2016 as 7.6%.
So now we can compare Verizon's ROA with Walmart's ROA. 5.6% for Verizon, 7.6% for Walmart.
Walmart's Net Income is higher than Verizon's, and Walmart's Total Assets are lower than
Verizon's, therefore Walmart's ROA is higher.
Now that we have done the ROA calculations, let's start investigating what is driving
these numbers.
I am pretty sure you will like the three suggestions I am about to give you.
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First suggestion: let's break down Return On Assets into its components of
Return On Sales and Asset Turnover.
You will see that Verizon and Walmart perform very differently on those!
Let's rearrange our numbers a bit to make this a clear comparison.
Verizon and Walmart company logos on the left, formulas at the top, and then let's fill in
the matrix with numbers.
We have already calculated ROA, Net Income over Assets, as 5.6% for Verizon in 2016,
and 7.6% for Walmart in 2016.
Now let's calculate ROS, Return On Sales, which is Net Income over Sales.
Sales, just like Net Income, is something we find on the income statement.
Verizon's revenue or sales in 2016 was $126B, so the ROS is $13.6B in Net Income divided
by $126B in sales, is 10.8%.
Walmart's revenue in 2016 was $482.1B. ROS for Walmart is $15.1B divided by
$482.1B in sales, is 3.1%.
Walmart's Return On Sales number or margin is much lower than Verizon's!
Asset turnover for Verizon is $126B in sales divided by $244.2B in assets, is 0.52.
Asset turnover for Walmart is $482.1B in sales divided by $199.6B in assets, is 2.42.
Walmart's Asset Turnover or speed or velocity is much higher than Verizon's!
So even though these companies on the ROA level look fairly similar, they arrive at
that ROA performance in very different ways.
Comparing Verizon and Walmart, you could say that Verizon gets to its 5.6% Return On Assets
with relatively high Return On Sales and relatively low Asset Turnover.
Walmart gets to 7.6% Return On Assets with relatively low Return On Sales and relatively
high Asset Turnover.
My second suggestion for more analysis on ROA is to look closely at what is going on
in the income statement.
Are there any unusual items that may have caused Net Income to be unusually high or
unusually low?
If you look at Verizon's Net Income over three years, you see it jump from $12B to $18.4B,
and then fall back down to $13.6B. Part of this is due to fluctuations in revenue and
the related gross margin effect on that revenue.
However, the effect of non-operational items in the SG&A line is very significant: Verizon
recorded significant severance, pension and benefit charges in 2014 and 2016, causing
the SG&A number in those years to be unusually high, and a credit in severance, pension and
benefit charges in 2015 which caused the SG&A number to be unusually low.
If costs go up, profit goes down.
If costs go down, profit goes up.
Another driver of the Net Income fluctuation is in the "Other Income and Expense" line:
Verizon had one-off costs for early debt redemption in both 2014 and 2016, which caused Net Income
in those years to be lower.
Without going into the exact details of each of the line items, the main message is that
just looking at one year's ROA like we did earlier for 2016 might not be fully representative
for a company.
If you take an average for two years, in Verizon's case the unusually high profit of 2015 and
the unusually low profit of 2016, you might get a lot closer to the underlying ROA performance.
My third suggestion for more analysis on ROA: dive into the denominator of assets, and see
what's in there.
For Verizon, what are the top 3 assets on the balance sheet by size?
Wireless licenses $86.7B which is 36% of the balance sheet total.
Plant, property and equipment of $84.8B. Goodwill of $27.2B.
For Walmart, property and equipment is the biggest asset category at $110.2B, then inventories
at $44.5B, and goodwill at $16.7B.
Knowing what is in the denominator of assets
is very interesting.
Are most of the assets current or non-current,
in other words are they assets that are already
cash or likely to convert to cash within the next year?
Verizon has $26.4B in current assets, Walmart $60.2B.
Which of these assets are tangible, which are intangible?
Thank you for watching!
If you enjoyed these examples of how to calculate Return On Assets, and how to analyze the drivers
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