## Profitability Ratios

After reading this section, you will have been exposed to the different types of profitability ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.

The return on assets ratio (ROA) measures how effectively assets are being used for generating profit.

#### LEARNING OBJECTIVES

• Calculate a company's return on assets

• Identify the limitations of using return on assets in financial analysis

#### KEY POINTS

• ROA is net income divided by total assets.
• The ROA is the product of two common ratios: profit margin and asset turnover.
• A higher ROA is better, but there is no metric for a good or bad ROA. An ROA depends on the company, the industry and the economic environment.
• ROA is based on the book value of assets, which can be starkly different from the market value of assets.

#### TERMS

• asset

Something or someone of any value; any portion of one's property or effects so considered.

• net income

Gross profit minus operating expenses and taxes.

#### Return on Assets

The return on assets ratio (ROA) is found by dividing net income by total assets. The higher the ratio, the better the company is at using their assets to generate income. ROA was developed by DuPont to show how effectively assets are being used. It is also a measure of how much the company relies on assets to generate profit.

$ROA = \frac{\text { Net income }}{\text { Sales }} \times \frac{\text { Sales }}{\text { Total assets }} = \frac{\text { Net income }}{\text { Total assets }}$

Return on Assets: The return on assets ratio is net income divided by total assets. That can then be broken down into the product of profit margins and asset turnover.

#### Components of ROA

ROA can be broken down into multiple parts. The ROA is the product of two other common ratios - profit margin and asset turnover. When profit margin and asset turnover are multiplied together, the denominator of profit margin and the numerator of asset turnover cancel each other out, returning us to the original ratio of net income to total assets.

Profit margin is net income divided by sales, measuring the percent of each dollar in sales that is profit for the company. Asset turnover is sales divided by total assets. This ratio measures how much each dollar in asset generates in sales. A higher ratio means that each dollar in assets produces more for the company.

#### Limits of ROA

ROA does have some drawbacks. First, it gives no indication of how the assets were financed. A company could have a high ROA, but still be in financial straits because all the assets were paid for through leveraging. Second, the total assets are based on the carrying value of the assets, not the market value. If there is a large discrepancy between the carrying and market value of the assets, the ratio could provide misleading numbers. Finally, there is no metric to find a good or bad ROA. Companies that operate in capital intensive industries will tend to have lower ROAs than those who do not. The ROA is entirely contextual to the company, the industry and the economic environment.