Return on assets (ROA) ratio is calculated by dividing the firm’s net income after interest and taxes by average total assets. Return on assets is important because a firm’s assets tend to represent the total value of the firm. If we look at the left hand side versus the right hand side of a balance sheet, we note that the firm’s total assets equal the firm’s debt plus equity. Knowing how efficiently management uses assets to create income is an important part of measuring managerial performance.
Often, we break down return on assets in terms of profit margin and asset turnover. In reality, firms often make decisions that accept a trade-off between profit margin and asset turnover. For example, a retailer could offer sales or lower prices that increase turnover but reduce profit margins.
*If we wanted to calculate gross ROA we would use EBIT rather than net income here.
The intuition from these formulas is that firms can increase return on assets by increasing their profit margin or their turnover, or both. However, since we know there is often a trade-off between the two in real life, this is often easier said then done.
Return on Assets (ROA)
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