By Neil Lindsay, BBA, MBA, Finance Lecturer and Tutor
© Neil Lindsay, 2016
Introduction
Based on the questions I’ve received over the years, and conflicting information available on the Internet, there seems to be a lot of confusion about how to calculate a company’s Return on Assets (ROA).
There is at least some consensus on what the denominator of the ROA ratio should be – the company’s Average Total Assets for the period. (Quibbles remain on whether certain assets should be excluded from Average Total Assets, but any adjustments would be driven by the objectives of your analysis. However, to quote from Hammy Hamster, “that’s another story”.)
Unfortunately, there appears to be two distinct views on what the numerator (i.e., the income flow to be measured) should be:
- Net Income, or
- Earnings Before Interest and Taxes (“EBIT”).
Ultimately, the appropriate numerator should be the one that is aligned with the denominator and the objective of the ROA ratio.
Objective of the ROA Ratio
The ROA ratio is used to evaluate how productively and efficiently the assets of a company are being used.
- First, are the assets generating a lot of revenue?
- And, second, are the assets and associated operating costs being managed efficiently to ensure that those revenues translate into margins that contribute to the bottom line?
“The ROA ratio is used to evaluate how productively and efficiently the assets of a company are being used.”
Net Income vs. EBIT
At first glance, Net Income seems to make sense as an appropriate numerator. After all, it captures revenues and operating expenses, and is used in the wildly popular Return on Equity (ROE) ratio.
However, Net Income also includes interest expenses, which are driven by the company’s capital structure choices (namely, how much debt it uses). What, then, are the implications of using Net Income as the numerator in ROA?
Well, let’s say Company A and Company B have the same amount and composition of assets, sales, and operating costs. But, Company A has no debt, while Company B is financed 50% with debt. In this situation:
- Due to the absence of any interest expenses, Company A would have a higher Net Income than Company B.
- And, therefore, the ROA of Company A would be higher than the ROA of Company B.
But do these differing ROAs make sense? If the objective is to measure how productively and efficiently the assets of a company are being used, then the answer is a resounding “NO”. With this objective in mind, we should not care how the assets in question are financed. We should only care about how the assets are being used by the firm. (Bonus points if Fisher’s Separation Theorem just popped into your head.)
Instead, we need a numerator that is untainted by the firm’s financing choices. Put another way, we need a measure of income for all of the assets quantified in the denominator, not just the portion of assets funded by equity investors. And, because it calculates earnings before interest expenses are deducted, EBIT fits the bill quite nicely. (Note: If an after-tax ROA is desired, EBIT can be adjusted to an after-tax number.) Whereas Net Income is a measure of earnings attributable to just the equity investment in the firm (or the portion of assets funded with equity), EBIT is a measure of earnings attributable to all of the assets of the firm.
“We should not care how the assets in question are financed. We should only care about how the assets are being used…”
Conclusion
Therefore, in this author’s opinion, ROA = EBIT/Average Total Assets. Under this formulation, the firm-wide numerator corresponds with the firm-wide denominator. And, most importantly, the ratio measures how productively and efficiently the assets of a company are being used, regardless of how the firm is financed.
As an aside, the debate over the ROA numerator likely stems from one of the major tensions between accounting and finance. Accounting classifies interest as an operating expense, whereas finance treats interest as a financing expense. These different approaches lead to a number of analytical issues beyond ROA – but that’s another story…
DISCLAIMER: Some authorities, programs and courses insist that ROA = Net Income/Average Assets, or perhaps some other formula. Therefore, depending on the circumstance and your objectives, you may wish to use these alternative definitions of ROA (e.g., to pass or maximize your grade in a program or course that uses an alternative definition).
Neil Lindsay, BBA, MBA is a finance lecturer and tutor who has been teaching finance to MBA, Executive MBA, and professional students for nearly fifteen years. He is also an award-winning finance and public policy professional, with private sector and pubic sector experience in corporate finance, capital markets, and risk management. Neil may be reached at neil@financetutor.net.
© Neil Lindsay, 2016
Originally published on LinkedIn on August 15, 2016.