Return on Assets Explained by the Business Ferret (2024)

Your business assets are more than just stuff that sits around you at the office; they are an investment with a return like any other. If you’re getting a return that you would never acceptfrom your IRA,you might be losing efficiency and destroying capital. Knowing the difference between your return on equity and your return on assets is the starting point; truly understanding performance for the latter is key.

Return on Assets Explained

Assets are your firm’s total assets, everything the company owns.Return on assets(ROA) for your business is calculated by dividing your net operating income after tax (but before other income or expenses like interest expense) by your total assets.

The return on your own assets can be compared to returns on other investments with their ownrisk profiles. Ifyour assets areonly returning 4% annually (after tax) compared to, say, a 6% yield on a junk municipal bond, wewould conclude that yourbusiness is under-performing by having all its assets tied up in your non-liquid, privately held business.If aninvestorwould declinesuch a low rate of return – particularly considering the risk of investing in a privately held business – why would youdo it in yourown company?

Let’s talk about leverage. Leverage is using debtto, hopefully, increase returns to the equity you invested. The amount of leverage does not change the return on whatever you purchased, it’s just a measure of how much you borrowed versus how much equity you used. ROAeliminates the effect of leverage – positive or negative – when a business uses debt financing (or when an individual does like in our mortgage example below).Return on equity (ROE), however, includesthe leverage and how it’s used.

Debt financing is a necessary component of any efficient finance strategy but it creates an illusion by generating two very different figures: return on assets and return on equity.The use of debt will either enhance or reduce the return on equity but it won’t affect the return on assets.

Return on assets and return on equity are often confused with each other and used incorrectly to determine the efficiency of debt financing. Return on equity is the percentage return on the amount owned outright or net of debt, either on a down payment or after paying down debt. Return on assets is the total return on all assets on an adjusted debt free basis, regardless of how much debt is actually used.

Comparison using return on equity can create a skewed perspective on a particular investment by potentially understating the risk and overstating the benefit. By leaving leverage out of the equation and using return on assets, you make a more useful and accurate comparison.

Amore complex problem comes when the cost of the debt and cost of equity, called cost of capital, exceeds the return on assets. In this situation, your business is financially inefficient anddestroying invested capital.Either the ROA needs to be raised or the cost of capital needs to be lowered for the business to avoid reduction in the company’s value and potentially financial failure.

Comparing returns on assets is a common method to size up the efficiency of one company over another in its use of invested capital. But a better comparisonis return on assets compared to thecost of capital supplied from both debt and equity. If return on assets is less than the cost of capital, that business is destroying wealth. How can thissituation be fixed? A few options are:

• Increasing net operating income and efficiency
• Trimming down assets
• Making sure that short term and long term debt financing is used effectively
• Eliminating excess cash balance holdings

Return on Assets Example

Most people unknowingly learn the basic art of leverage when they purchase their first home. This is a great way to explain how ROA works because it covers all the different components discussed above in a scenario most people are familiar with – buying a house.

Let’s say you’re purchasing a home for $500,000 and you put 20% down. Your equity in the home is $100,000 and the amount borrowed is $400,000.

Now, let’s say your house is appreciating at 5% annually. Congratulations! This is the return on assets for your house, which can be compared with the return on any other investment.

The return on your equity, however, is typically going to be much higher than the 5% return on asset – the house due to the leverage. Let’s assume the mortgage interest rate is 3% or $12,000 interest expense per year. Subtracting that interest expense on debt from the overall ROA at $25,000 would yield a net $13,000. This $13,000 would be allocated to you and your equity. So $13,000 divided by the $100,000 down payment would equal a return on equity (ROE) of 13% or 2.6 times the ROA. Of course, we are ignoring principal payments and taxes to keep the illustration simple. A novice investor would feel like a real geniusbut we’re not looking at the right number.

Now, let’s make sure that this particular investment is a good one by looking at the cost of capital for the total capital employed in this investment – debt and equity. Using the mortgage interest rate of 3% and assuming a required or competitive equity the cost of capital can be determined – what is called weighted cost of capital. In our example the debt is 80% and the equity will be 20%. Let’s further assume that the required return on equity needs to be a minimum of 20% for the risk/reward trade-off. Under these assumptions the weighted cost of capital is 6.4% (3% times 80% plus 20% times 20%).

So with the cost of capital at 6.4% and the ROAat 5%, the investment is destroying wealth. Few people analyze real estate investments this way, even though it isthe primary way to understand and make all successful financial decisions.

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