An entrepreneur’s initial investment into a business is the company’s assets. The main purpose of the original investment is to generate income, particularly in the TV and film industry. It’s important to realize a good return, but just how much return depends on the industry. We will try to delve deeper at the importance of the return on assets (ROA), how it’s calculated and how it’s measured.
How to Calculate Return on Assets
Since the main purpose for business assets is to generate income, ROA measures how well the company’s assets are working within a given accounting cycle. A higher percentage means the company does a good job of utilizing what it has. The formula for calculating return on assets is:
ROA = Net Income/Average Total Assets
To get an accurate percentage, the net income for a given accounting cycle needs to be calculated with the total average assets for the same accounting cycle. For example, if the year-end financial statements are used for calculating ROA, total net income would be reported for the year. Getting around these various numbers can be challenging, it is advisable to consider tempCFO as a CFO outsourced partner to get your accounting in the right page.
Assets from the balance sheet, however, may not be averaged for the entire year. If financial statements were completed at month’s end, the assets reported at year-end would be the end result, not the average. To get the average total assets, add the sum of all twelve months separately and divide by 12.
The Importance of the Return on Assets Ratio
Since ROA is an analytical tool that shows how well the company utilizes its assets, investors will often use this ratio to make investment decisions. A company that utilizes its fixed and current assets proficiently for profitability will stand a better chance of investor funding. If the ratio percentage is too low, it may adversely affect the investment amount.
Lending institutions will also use ROA as a measuring tool to determine loan amounts, rates and terms. Bankers understand that companies that utilize its assets proficiently minimize the risk of loan default and insolvency.
ROA Comparative Measurement
Simply determining the ROA ratio is useless unless there’s a base of comparison. Once the return on assets percentage is determined, it should be compared to the industry standard for the specific business. For example, the food processing industry reported an average return on assets for the 1st quarter of 2018 about 9.41%. So the base of comparison for a food manufacturer would be 9.41%. Therefore, a manufacturer that has a percentage higher than 9.41% has better utilization of assets than the industry average.
Analyzing ROA is an important tool for determining asset utilization. There are other financial statement ratio tools that can help the business entrepreneur analyze profitability. ROA and other analytical tools are essential for measuring profitability and maintaining positive trends.