Blog #08 - Return On Asset

 

In Blog #07 we saw Return On Capital Employed, in this blog we shall see Return On Asset. We have already seen Return on investment, Return on RoCE and Return on Equity. Now we shall see return on asset in this blog. Return On Asset of a company is a measure to check how the company is good at utilizing its assets. It means how fast is production of the company using the same assets and this will give good returns on the other hand a second company may not utilizing it assets which will lower the production for the company this means it may happen that its assets are idle. In this blog we will see how to calculate return on asset and how to compare RoA for two or more companies.  

 

Return on Asset : Illustration

 

This is the part of profitability ratio. As we saw in profitability ratios that return on investment have three categories namely RoE, RoCE and Return on Asset. As per definition Assets = Equity + Liabilities. If you see the typical income statement of a company, generally, you will see Assets on left side and equity on right side. Let say the value of Assets are 4 crore while value for equity and liabilities are 50% of assets and so it will have same weight i.e. 2 crores each. As we saw in blog #07 there are two types of liabilities namely current (liabilities with < 1year) and non-current liabilities (liabilities with > 1year). Similarly assets have two types current assets (<1 year) and non-current assets (>1 year).  

 

 

Whenever we want to calculate return on asset it means we want to figure out how the company is performing in utilizing its assets. The profit that the company makes on the asset will show the Return On Assets of the company and the company with good RoA will be better than other. Let take an example i.e. the income statement of a company.

 

 

Income statement

PBIT             8000000 (operating profit)

Interest        2000000

PBT              6000000

Tax@30%     1800000

PAT              4200000 (net profit)

Now by the mathematical definition if we calculate RoA then it will be, RoA = Profit/Assets. You will find Assets easily from the balance sheet but what should be taken instead of profit, PBIT or PBT or PAT. Here again the calculation becomes complex and different analysts uses different approach, we will see them. During the calculation of RoE we saw the mathematical formula as RoE = PAT/Total Equity. In this interest is paid out first means short or long term debt liabilities after that on second number tax to govt. and then return to equity share holders are paid out. 

 

RoA : How Company is good at utilizing its assets.

 

In the calculation of RoA you will find RoA = PAT / Total Assets, this is not bad to use this formula but ideally as per me interest expenses should not be covered because PAT is considered in equity returns, here we have included all assets along with liabilities so we should not cover interest expense ideally, so if you have PAT then add Interest to it and subtract the interest on the tax. According to this mathematical definition will be (PAT+Interest-Interest on Taxes)/Total Assets. And some time PBIT is also taken as profit during calculation and this is also fair to use. But you have to remain consistent with one formula that you are using. If you calculate RoA using three formulas you will get 10.5%, 14% and 20% which is different for each case. Use any of the formula while calculating RoA for two different companies. Let take two different companies whose results are:

 

	Company A	Company B
PBIT	8000000	20000000
Interest	2000000	3000000
PBT	6000000	17000000
Tax@30%	1800000	5100000
PAT	4200000	11900000
Equity Cap.	20000000	35000000
Liability	20000000	30000000
Total Assets	40000000	65000000

 

RoA for company A by the formula PBIT/Assets will be 20% and RoA for the company B using same formula is 30.8% and from this we can know that company B has good RoA than Company A because RoA (A) < RoA (B). Good RoA for company B shows it is good at utilizing its assets than company A. 

 

 

Important Points about RoA:

#01.   Company with better RoA is utilizing its assets better.

#02.   RoA can be increased by increasing PBIT or decreasing Assets. If we increase it by increasing PBIT then we have to consider better pricing, economies of scale, lower costs with better efficiency and productivity. If we decrease assets then we have two types of assets current and non-current. In this case we have consider reducing accounts receivables, better inventory turnover, higher asset utilization, leasing instead of buying and divesting lower margin business/assets. By any one of formul discussed as we can get RoA.