Thursday, July 17, 2008

Impact of ROA on company’s efficiency

A little extra doesn’t hurt. Definitely, but what if it’s much greater than a little? In that case, a company’s ROA (Return On Assets) can face an adverse impact. Let’s see how.

• Return on Assets

The financial measure accepted widely by the entire business community as a firm’s capability to manage its assets and thereby, a measure of the company’s efficiency, return on assets is also a measure of a company’s economic profitability. The calculations by which ROA is determined is:

ROA= Net Income/Assets.

This signifies ROA or returns on assets to be inversely proportional to the amount of assets, making most companies target maximum net income by minimizing the assets level. Asset management, in other words - return on assets is an answer to the question of generation of profit by a firm by using its assets.

ROA also helps evaluating managerial skills and therefore, determines a large part of the compensation paid to them by the employer. For companies trading publicly, return on assets is one of the factors that investors monitor closely. That makes return on assets a vital part of stock management and it has a direct impact on a company’s stock price.

Now, ROA has a few points attached to it, which one must know before carrying out the discussion any further.

 Return on assets is independent from the measures a firm undertakes for financing its assets.

 ROA is usually defined on a pre-tax basis. It is done for making international comparisons possible.

 ROA compares profitability among several firms practicing financing strategies that are different from each other.

• Improving Efficiency

Assets of a company comprise both equity and debt, which fund the company’s operations. The figure exhibited by return on assets provides investors an estimate on a company regarding how efficiently can it convert the investment to a net income. A higher ROA number depicts a company to be earning more by investing less. Therefore, company A with a net income of $1 and total assets of $5 (ROA = 20%) is converting its investments more than company B earning $1 with $10 of assets. All in all, it’s about making a large profit with a minimum of investments. For credit unions as well, ROA is an important phenomenon in particular. It is because the retained earnings of a credit union make source for additional capitals that are needed by the regulators for making a credit union grow and benefit from the economic scale. ROA, therefore, to regulators are also a tool for stock management that helps in issuing the stocks and bonds to investors outside the company.

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