Return on Total Assets Ratios provide analysts with an indication of management efficiency in utilizing company assets to create profits. Because it includes all (total) assets (assets funded by debt and equity) it is a profitability ratio that interests both creditor and equity stakeholders.
As a value investor our first priority is to purchase investments for less than their intrinsic value. But value investors that favor holding stocks for many years (i.e. Warren Buffett) need to combine value with quality.
How to Calculate Return on Total Assets
If you don’t buy quality you need to sell your investment when its price gets close to its real value. There is nothing wrong with this strategy. Sometimes the price of a stock is so low that, even though it may lack the characteristics of a quality investment, it is still a bargain worth buying.
With a quality investment you have the option to hold it longer than other investments. The expectation is a quality company that will grow earnings at an above average rate. These advantages (i.e. superior management, strong balance sheet, operating efficiencies, etc.) increase the probability that the company will experience above average growth in its stock price.
One of the ways to find quality companies is to see how efficiently the management of a company is employing its assets. Here are six return on assets ratios analysts use to measure efficiency.
1. Return on Assets (ROA)
Return on Assets (ROA) = Net Income / Total Assets
Net Income = Revenue – Cost of Goods Sold – Other Expenses
(Find Net Income is the bottom line of the Income Statement)
Total Assets = Current Assets + Long Term Assets
(Total Assets is the bottom line of the assets portion of the balance sheet.)
ROA is the broadest return on assets metric for measuring income in relation to company assets. It tells you how efficiently the company is using the assets of the business to create net income.
This is useful in comparing between similar companies. Since it does not take into account capital structure it is best used to compare companies in the same industry. In addition, since net income can be volatile, it is best to compare over a number of years.
2. Cash Return on Assets
Cash ROA = CFO / Total Assets
Cash Flow From Operations = Net Income + Depreciation & Amortization +/- Time One-Time Adjustments +/- Changes in Working Capital
(Find Cash Flow From Operations is the bottom line of the operating activities in the Cash Flow Statement.)
Cash Flow is considered by most analysts to be superior to accounting metrics (such as Net Income) that can be distorted by non-cash accounting entries. Cash Return on Assets measures how efficiently the company’s assets are being utilized to create cash returns.
3. Gross Profitability
Gross Profitability = Gross Profit / Total Assets
Gross Profits = Revenue – Cost of Goods Sold