Return on Assets
Assets are your firm’s total assets, not just what the company owns. Return on assets is calculated by dividing net operating income after tax (but before other income or expenses like interest expense) by total assets.
Return on assets can be compared to other returns with similar or different risk profiles. For instance, if your business is only returning 4% annually (after tax) compared to, say, a 6% yield on a junk municipal bond, one could conclude that the business is under-performing for the risk taken by having all assets tied up in an non-liquid privately held business – its own. If few would accept such a low rate of return in general, particularly considering the risk of investing in a privately held business, why would someone do it in their own business?
It all comes down to leverage and how it’s used. Leverage is the use of debt to, hopefully, increase returns. Most people ...view middle of the document...
Return on assets eliminates the effect of leverage, positive or negative, when a business uses debt financing – or when an individual does like in our mortgage example above. Debt financing is a necessary component of any efficient finance strategy but it creates an illusion by comparing return on assets and return on equity. The use of debt will either enhance or reduce the return on equity but it won’t affect the return on assets.
The real problem comes when the combined cost of the debt and equity, the cost of capital (cost of capital, another key financial metric), exceeds the return on assets. When your cost of capital exceeds your return on assets, your business is financially inefficient and destroying invested capital.
In the mortgage example above, if the return on assets on the house is 5% per year and the mortgage interest rate is 5%, the cost of capital would be 9% (calculated using this formula). This excludes taxes and the current poor real estate market performance, which, when combined, would increase the gap between return on assets and cost of capital even further.
This real estate investment would destroy capital because the cost of capital of 13% is far higher than the return on assets of 5%. Few people analyze real estate investment in this way even though this is the only way to truly understand make a good financial decision.
When comparing your return on assets to other, similar businesses, it’s important to make the correct comparisons. Be sure that you are using return on assets not return on equity. Comparing returns on assets is a common method to size up the efficiency of one company over another in its use of invested capital.
A better comparison, however, would be to make sure that the return on assets exceeds the cost of capital supplied to the company and invested in the total assets of the company. If return on assets is less than the cost of capital there is problem. How can it be fixed? By increasing net operating income, trimming down assets, and making sure that debt financing is used efficiently.