What Is Return on Assets (ROA)?
The return on assets is an accounting metric that measures the return of a company’s profits relative to its total assets. The higher the ROA of a company, the more efficiently it is utilizing its assets.
The formula for Return on Assets is pretty straightforward:
Net Income
Net income also referred to as the bottom line of every business, can arguably be considered the single most important financial number that both companies and investors constantly keep an eye on. Net income is essentially the accounting earnings left within a company after all costs that were directly associated with the produced goods (COGS), operating expenses (such as selling, general and administrative expenses) have been deducted, and financial expenses like interest payments and taxes have been paid.
Net Income is normally measured over a certain time period (in most cases on a quarterly and annual basis) and can be found on a company’s income statement.
Total Assets
Assets are any type of resource with economic value for a company and are used within a firm’s operations in order to generate cash flows. On the balance sheet, the value of all assets is equal to the sum of liabilities and equity, implying that assets can be either financed through equity or debt.
We use assets in the numerator of the calculation since we want to assess the efficiency of a company’s assets.
The book value of all assets within a firm can be found on a company’s balance sheet and isn’t measured over a time period. Instead, the balance sheet can be viewed as a snapshot of a company’s financials at a certain point in time (usually at the end of a fiscal quarter or fiscal year).
What Can Cause a Negative ROA?
A company can only have a negative ROA metric when costs are oveweighing revenues which leads the company to report negative earnings. Since the net income plays its role in the denominator of the calculation, any negative number will consequently result in a negative ROA.
A negative return on assets implies that the company isn’t able to acquire or utilize its assets sufficiently enough to generate a profitable return.
Negative net income isn’t necessarily uncommon for many companies and can occur as a result of various reasons and circumstances. Young companies, for instance, will often find themselves in an early stage of their corporate life cycle and thus be unprofitable at first.
Of course, negative earnings can also be a strong sign of financial distress within a company. Businesses that are consistently unprofitable, while not being able to show adequate revenue growth, can quickly go out of favor to investors. If a company isn’t able to generate excess cash flows till the point where it can no longer pay its due debt, it will face bankruptcy.
In either way, there is no general rule in assessing companies with negative earnings which is why the company’s individual circumstances will need to be analyzed.
Example: Wix.com Ltd. and Squarespace, Inc.
As an example, let’s suppose we wanted to calculate the ROA of WIX.com and Squarespace, two fairly similar companies that host and build websites for companies and individuals.
Wix.com Ltd. (WIX)
Wix-com reported a net income of -$165,15 million on its income statement for the fiscal year ending in December 2020. Having a look at the most recent balance sheet tells us that Wix.com’s total assets equaled $1,893 billion in 2020. As a result, Wix.com’s most recent fiscal year ROA was -8,7%.
Squarespace, Inc. (SQSP)
Squarespace’s net income totaled $30,59 million in 2020, whereas the company’s assets were $306,77 million as of the end of 2020. Dividing the net income by the assets gives us a ROA of roughly 9,97%
In this case, a lower or negative ROA doesn’t necessarily suggest that a company would be worse than its competitor. Despite the negative ROA, Wix.com is trading at a considerably higher market capitalization than Squarespace, not only because it generally is a bigger company but also because investors are willing to pay higher premiums.
Note that it’s important to stay consistent within the assessment. In this example, we compare two companies that are operating within the same industry since it doesn’t make any reasonable sense to compare the ROA of firms from two different industries that have entirely different capital requirements and business models.
How to Assess a Negative ROA
Applying return metrics such as the return on assets on unprofitable companies will essentially be meaningless since that wouldn’t reveal any useful insights other than that the firm was unprofitable. That being said, there are some variations and other return metrics that can be used as an alternative.
Calculating Return on Assets with Operating Income
There is a strong argument that using operating income in the numerator instead of net income is actually the more accurate approach in calculating ROA.
The reason is that since the assets within a company are financed both by equity investors and creditors, the operating income should be used in order to stay consistent with the numerator as that line represents the income attributable to the whole firm (equity and debtholders). Net income, on the other hand, are the earnings that are only attributable to the equity holders of the firm.
The additional benefit of this type of formula is that this may apply to companies that don’t report positive earnings in the first place. Operating income represents the earnings from a company’s operations before interest, tax, and other expenses are deducted. This may allow for the comparison of different companies even if one firm is profitable yet (supposing that they both report positive operating income).
Calculating Return on Capital (ROIC)
Another (and probably better) alternative to return on assets is the return on invested capital:
One primary difference between ROIC and ROA is that in the ROA calculation, we use the book value of all assets as the denominator which results in a higher number compared to the invested capital used in ROIC. This leads to ROIC generally being higher than ROA.
In this case, EBIT (or operating income) is used in the numerator and adjusted with the tax rate of the company.
ROIC is widely used in finance not only because it makes up a great measure of a company’s efficiency but also because it can also be directly compared with a company’s cost of raising debt and equity (cost of capital).
Learn more about the return on invested capital.
Conclusion
The return on assets of a company can quickly turn negative as soon as a firm is unprofitable, which instinctively diminishes the usefulness of the metric. In that case, it can be helpful to either deviate to alternative metrics or assess the discrete circumstances that led to the company’s unprofitability.
