Title: Significance of Return on Assets (ROA) & its correct computation for determining the profitability of a company.

Return on Assets (ROA) is an important criterion to judge the profitability of the company. It measures the profitability of the company in relation to its resources. Often the management of the company is in the dilemma ‘What to do with the assets available?’ ROA answers this question for them. ROA for capital intensive company will be relatively low as compared to company with low capitalization. This is because capital intensive company requires large amount of assets to do what it does. At the same time capital intensive company will have more no of assets that can be turned into money at the time of failure.

Methodology

I have tried to highlight the importance of the Return on Assets for a company by taking two cases.

In the first case I have taken the example of a largest producer of steel, ‘Steel-giant’. The management of this company is under a lot of stress due to their decreasing return on assets. So here the importance of correct computation of ROA is highlighted by using payments made to both lenders and owners in the numerator.

In the second case I have taken the example of two companies ‘PM’&‘IT’. PM is having high profit margin and IT is having high Investment turnover. I have highlighted the importance of ROA in this case by using Du-Pont analysis.

Problem Statement 1

Steel -giant is a leading producer of steel in India. It is a public sector undertaking which is mainly owned by Government of India.  It started its operation in India in 1954 and has slowly and steadily become the steel market leader of India. India’s steel industry from last 6 years has seen a lot of turbulence due to sharp decline in global commodity prices. As a result of which Steel-giant has seen a sharp decline in profits. This has in turn led to reduced Return on Assets.

After facing huge decline in profits and return on assets, the company now is being led by a dynamic chairman from last two years. His continuous efforts and India’s push for infrastructure projects has led to increase in profits in the current year. He asks for the financial data of last 4 years from his accountant which is given below:

Important data

2017

2016

2015

2014

Total Assets

426.5

411.5

407.6

411.8

EAT

1.8

-0.2

4.4

5.2

Interest

5.2

4.9

5

5.5

Tax Advantage

1.82

1.715

1.75

1.925

The chairman understands the importance of ROA and hence wants to find out Return on assets (ROA) of last 4 years and compare it with the industry figures. The accountant calculates ROA based on the conventional method:

ROA= (EAT/ Total assets)*100

So this gives return on assets for:

2014 = 5.2/411.8 = 1.26%

2015 = 4.4/407.6 = 1.08%

2016 = -0.2/411.5= -0.05%

2017 = 1.8/426.5 = 0.42%

Chairman looks at the calculations of accountant and realizes there is some fault in the calculations. As the ROA calculated is less as compared to the other industries having nearly same EAT. So he hires a consultancy service ‘Think different consultancy services’ to advice him regarding the correct calculations and other steps to improve ROA. The consultant of the company after looking at the calculations instantly informs the chairman about the correct concept.

Solution:

He says that ROA calculated using conventional method is an underestimate of profitability as EAT is a reward to shareholders. Actually assets are financed both by shareholders funds and debt-holders funds. So, the numerator should also include reward made both to the owners and lenders. So the numerator will be inclusive of interest paid to debt-holders. (Reference: Page 4.34, Management Accounting by Professor P.K. Jain)

So Real ROA= (EAT+ Interest- Tax advantage on interest)*100/ (Total Assets)

Based on this formula he calculates ROA as follows:

2014 = (5.2+5.5-1.92)/411.8 = 2.13%

2015 = (4.4+5.0-1.75)/407.6 = 1.88%

2016 = (-0.2+4.9-1.715)/411.5 = 0.72%

2017= (1.8+5.2-1.82)/426.5 = 1.21%

The chairman understood the usefulness of the formula suggested by the consultant after seeing the ROA improving considerably for all the years. Consultant further inquired about the assets of the company like Land, plant & machinery as he was aware about the vast amount of land lying unused in the PSUs.

He found that more than 100 acres of land was lying unused in various plants of Steel-giant. He also observed that the company like other steel companies was battling a flood of cheap imports from china inundating the company with cheap supplies. So some amount of plant & machinery was also lying unutilised. So he estimated the total unused assets of about 30%.

He now calculated the ROA based on Total assets actually used:

 (Eat + Interest-Tax Advantage)*100/ (Total Assets)*0.7

2014 = 2014 = (5.2+5.5-1.92)/ (411.8)*0.7 = 3.04%

2015 = (4.4+5.0-1.75)/ (407.6)*0.7 = 2.68%

2016 = (-0.2+4.9-1.715)/ (411.5)*0.7 = 1.04%

2017= (1.8+5.2-1.82)/ (426.5)*0.7 = 1.73%

This concept helped chairman to understand that ROA is based on the concept of assets actually used to generate profit as the ROA of Steel-giant now became comparable to other steel companies earning same amount of profit. So the Chairman got to know that assets which are not in use are not contributing to EAT so they shouldn’t be used in the calculation.

Some recommendations were also given by the consultant:

1.      He observed that the other expenses like travelling expenses, scrap recovery expenses, maintenance expenses, etc. formed a major part of the company’s expenses. Since the company is already facing issues of less margins so he insisted on reducing these miscellaneous expenses.

2.      Company has a huge amount of land lying as waste. This land is currently unproductive and company at this position can’t afford this. If the company doesn’t have any plans of expansion in future it can rent this land to generate income. Another option is to sell the land to fund its operations but that will only be a short term boost. So the company should quickly come up with plans to either diversify its business or rent the unused land.

3.      Lastly it should not allow the machinery to be unutilised for long periods of time. Because the cost of machinery is a fixed cost, it will continue to be incurred even if it is not put to use. So company should ensure maximum utilization of its installed capacity, so that proper utilization of assets can be done.

Problem Statement 2

This problem is related to two companies PM & IT. Both the companies are generating same ROA form two years which is close to 9%. Both of them have approached the same consultancy service ‘Think different consultancy services’ to know about the reasons of low ROA and also the ways to improve it.

Important financial data of PM for 2 years is given below:

Important data

2017

2016

Sale

80.8

80.6

Earnings after tax

6.5

6.2

Average Total Assets

70.2

69.2

Important financial data of IT for 2 years is given below:

2017

2016

Sale

140.2

138.5

Earnings after tax

1.5

1.4

Average Total Assets

15.5

15.1

Solution:

The consultant is fully aware about the Du-Pont analysis and how he can use it to find about the real reasons of less ROA.

So, first of all he performs analysis on data of PM:

Net Profit margin = EAT/ Sales

2016 = 6.2/80.6= 7.69

2017 = 6.5/80.8 = 8.04

Investment Turnover = Sales/ Average Total Assets

2016 = 80.6/69.2 = 1.16

2017 = 80.8/70.2 = 1.15

By Du-Pont analysis ROA= Net Profit Margin*Investment Turnover

2016 = 7.69*1.16 = 8.96

2017 = 8.04*1.15 = 9.26

After doing this analysis the consultant gave them recommendations:

1.      He explained the company ‘PM’ that they were just concentrating on increasing their net profit margin which is only one factor in calculating ROA. They also need to concentrate on other important factor which is Investment turnover.

2.      They can improve their turnover by increasing their sales by employing effective marketing strategies. They can have better utilisation of assets to improve their Investment turnover. As it is clearly visible from the data they are using large amount of assets to generate sales.

Analysis on data of IT:

Net Profit margin = EAT/ Sales

2016 = 1.4/138.5 = 1.01

2017 = 1.5/140.2 = 1.07

Investment Turnover = Sales/ Average Total Assets

2016 = 138.5/15.1 = 9.17

2017 = 140.2/15.5 = 9.04

By Du-Pont analysis ROA= Net Profit Margin*Investment Turnover

2016 = 1.01*9.17 = 9.27

2017 = 1.07*9.04 = 9.68

After doing this analysis the consultant gave them recommendations:

1.      Unlike company PM they were concentrating only on Investment Turnover. But there net profit margins are very low.

2.      To address the issue of low net profit margins the consultant advised them to economise their costs or reduce their expenses. This will lead to increase in EAT and hence the net profit margin.

So by using Du-Pont analysis consultant could clearly bring to the fore the areas which required more attention from management.

By using both these problem statements I wanted to drive home the point that ROA is very important factor in assessing the firm’s profitability. It is more important for companies having huge chunk of unused assets. It highlights the importance of proper utilization of assets, because if unused assets are brought to use the companies can also address the issues of rising NPAs.