ROA Discussion

Return On Assets

DISCUSSION

            Return on assets is the ratio of the amount of income a company would report if it had no debt or preferred stock to its average total assets.

            Average total assets usually are calculated as the average of assets reported at the beginning and end of the fiscal year. If a company had no debt, it incur no interest expense. Therefore, interest expense is added back to net income. This calculation is complicated by the fact that interest expense is deductible from income taxes. Therefore, if no interest expense was incurred, no deduction would be made from taxes. To correct for the tax effect, interest expense is added to net income after considering the tax effect. This adjustment is made by multiplying interest expense by 1 minus the tax rate. The tax rate can be estimated as the ratio of income tax expense to pretax income. Preferred dividends are not subtracted from income in computing return on assets, because the measure presumes no preferred stock exists.

            Companies that generate high return typically are high-growth, high-value companies. They invest large amounts in new assets to provide a basis for producing and selling additional goods and services. Companies in industries that require large investments in long-term assets tend to be more stable than less capital intensive companies. These stable, slow-growing companies are in the middle of the value range.

            There are two acceptable ways to calculate return on assets.

Option 1:

Net Profit Margin x Asset Turnover

Option 2:
                                 Net Income + Interest Expense(1-Tax Rate)
Return on Assets = ______________________________________

                                             Average Total Assets

            The lower the profit per dollar of assets, the more asset-intensive a business is. The higher the profit per dollar of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy [manufacturing, railroads], anything above 20% is asset-light [advertising firms, software companies].

J&G 2005 Income Statement Excerpt
Period Ending:	Sep 30, 2005	Sep 30, 2004	Sep 30, 2003
Total Revenue	$18,427,200,000	$17,154,600,000	$16,139,400,000
Cost Of Revenue	$478,300,000	$472,400,000	$419,600,000
Preferred Stock and Other Adjustments	($8,800,000)	($9,800,000)	($13,000,000)
Net Income Applicable to Common Shares	$469,500,000	$462,600,000	$406,600,000

J&G 2001 Balance Sheet Excerpt
	2005	2004	2003
Long Term Assets
Long Term Investments	$300,500,000	$254,700,000	$254,700,000
Property, Plant and Equipment	$2,379,800,000	$2,305,000,000	$1,996,000,000
Goodwill	$2,247,300,000	$2,133,300,000	$2,096,900,000
Intangible Assets	N/A	N/A	N/A
Accumulated Amortization	N/A	N/A	N/A
Other Assets	$439,900,000	$457,800,000	$457,700,000
Deferred Long Term Asset Charges	N/A	N/A	N/A
Total Assets	$9,911,500,000	$9,428,000,000	$8,614,200,000
Total Stockholder Equity	$2,985,400,000	$2,576,100,000	$2,270,000,000
Net Tangible Assets	$738,100,000	$442,800,000	$173,100,000

The first option requires that we calculate net profit margin and asset turnover. In most of your analyses, you will have already calculated these figures by the time you get around to return on assets. For illustrative purposes, we’ll go through the entire process using J&G as our sample business.

Our first step is to calculate the net profit margin. We divide $469,500,000 [the net income] by the total revenue of $18,427,200,000. We come up with 0.025 (or 2.5%).

We now need to calculate asset turnover. We average the $9,911,500,000 total assets from 2005 and $9,428,000,000 total assets from 2004 together and come up with $9,669,750,000 average assets for the one-year period we are studying. Divide the total revenue of $18,427,200,000 by the average assets of $9,660,750,000. The answer, 1.90, is the total number of asset turns. We now have both of the components of the equation to calculate return on assets:

.025 [net profit margin] x 1.90[asset turn] = 0.0475, or 4.75% return on assets

The second option for calculating ROA is much shorter. Simply take the net income of $469,500,000 divided by the average assets for the period of $9,660,750,000. You should come out with 0.04859, or 4.85%. [Note: You may wonder why the ROA is different depending on which of the two equations you used. The first, longer option came out to 4.75%, while the second was 4.85%. The difference is due to the imprecision of our calculation; we truncated the decimal places. For example, we came up with asset turns of 1.90 when in reality, the asset turns were 1.905654231. If you opt to use the first example, it is good practice to carry out the decimal as far as possible.

Is a 4.75% ROA good for J&G? Our research has shown that the average ROA for J&G’s industry is 1.5%. It appears J&G’s management is doing a much better job than the competitors which is of course a good news to its investors.

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