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Thursday, December 24, 2009

What is the Return on Assets (RoA) ratio?

The Return on Assets (RoA) ratio is a measure of profitability of a company relative to its total assets (which includes share capital plus all its short-term and long-term loans). It tells us how effectively and efficiently a company's management is utilising its assets to generate a profit.

There are a few different ways to calculate the RoA ratio (also called the Return on Investment ratio). The simplest is to divide the net profit during a 12 month period by the total assets. In other words,

Return on Assets (RoA) ratio = (Net profit / Total assets) x 100

If the Net profit of a company is Rs 5 Crores and total assets is Rs 100 Crores, then the RoA will be 5%. Another company may earn Rs 10 Crores on total assets of Rs 100 Crores. Its RoA will be 10%. Needless to say, the higher the RoA the better. Which means the company is able to generate more profits with less or equal amount of investment.

An RoA of 15% is considered the benchmark for profitability. But the figure is different for different industries. Therefore, the RoA should be used to separate the men from the boys within an industry or sector - and not used for comparing across sectors.

Why? Let us take a Bharti or RCom. They need to constantly invest in new equipment and towers for growth. Or, a Maruti or Tata Motors that need to innovate and invest in new models and infrastructure. Likewise, for power generating businesses like NTPC or Suzlon; airline companies like Jet and Kingfisher; metal producers. Such companies are asset-heavy. Therefore the RoA ratio tends to be 5% or lower.

Contrast these sectors with some asset-light ones like software services or travel services or brokerages. All you need are some furniture and computers and you are in business. Naturally, the RoA ratio is 20% or higher, because the real assets in these sectors are people.

The financial sector, particularly banks, need to constantly borrow money to loan it out again. So the RoA ratio can be as low as 1%. What is a small investor to do? Avoid banks and manufacturing, and only invest in services companies?

Obviously not. That would be putting all your eggs in one basket. Therefore, use the RoA ratio to find out which banks, or auto makers, or steel and power companies are more profitable than their peers in the same sector.

Some prefer to add the interest expenses to the net profit to calculate the RoA ratio. Others add the working capital requirements to the total assets. Which particular formula to use depends on the type of sector being analysed.

There is another formula to calculate RoA:

Return on Assets (RoA) ratio = (Net profit margin x Asset turnover ratio) x 100

where, Net profit margin = Net profit / Sales

and, Asset turnover ratio = Sales / Total assets

Mathematically, the second formula is the same as the first, but gives us a different view of a business. It shows that profitability can be attained in two different ways. The first is by increasing the net profit margin (by reducing costs, or better still, by charging premium prices - like the Tanishq retail stores of Titan). The second is by turning over your assets many times during the year (a practice followed by discount retail stores, like Pantaloon).

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How to distinguish between a good company and a great company
(Wishing all my blog readers from near and far a very merry Christmas and a happy 2010.)

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