The formula is relatively simple, however it isn’t necessarily a pure formula. There are important variables with the formula including non-performing assets, accelerated depreciation and the impact intangible assets have on the results. In addition, companies in the growth part of the business life cycle may want to adjust the result for this growth rate in order to separate management efficiency from natural market gains. The following sections explore and elaborate on how to interpret the results of this ratio. The final section will explain why it is important to establish a relevant range and not use the result of this ratio once the outcome exceeds the range limits.
To begin, let’s understand the fundamentals of the formula.
- 1 Fundamentals of Return on Assets
- 2 Asset Changes
- 3 High Growth Rates
- 4 Setting a Relevant Range for Return on Assets
- 5 Summary – Return on Assets
Fundamentals of Return on Assets
To grasp the fundamentals of this formula, the reader must first understand the basic formula and the elements comprising the formula’s numerator and denominator.
The basic formula is:
The net profit refers to the bottom line as reported on the income statement. The assets are all assets as indicated on the balance sheet. To make sure the reader understands the formula correctly, it is the net profit reported for the year divided by the asset balance at the beginning of the year. If you use the assets at year end as the denominator, the results will typically be lower. How so? Let’s look at a simple example.
The Shiloh Trading Company has $1,000,000 of assets on January 1 and earns a net profit of $200,000 for the calendar year. There are no distributions/draws/dividends paid during the year. Here is the balance sheet in summary format for the beginning and ending balances for the fiscal (calendar) year.
ASSETS Jan. 1 Dec. 31
Cash $150,000 $250,000
Inventory 650,000 700,000
Fixed 200,000 250,000
Total Assets $1,000,000 $1,200,000
LIABILITIES $300,000 $300,000
EQUITY 700,000 900,000
Total Liabilities & Equity $1,000,000 $1,200,000
The equity increases $200,000 which reflects the current earnings for the year. The results of the formula are significantly different depending on whether the user utilizes the beginning of the year assets value or the year end value. Here are the results:
So there is a significant difference in the results depending on the respective asset value used. As with investment portfolios, the beginning asset balance is more appropriate than the ending balance. However, in business it is not as simply as this as other factors impact the results. To start out, let’s see what is happening throughout the entire year.
In reality the asset balance is constantly changing as income is earned throughout the year. For example, if the profit is level for all 12 months, then after January the equity increases to $716,667 (($700,000 + ($200,000/12)). So the remaining 11 months have a minimum starting basis of $1,016,667 in assets. This pattern continues throughout the calendar year.
A more accurate formula is the net profit divided by the average assets value for the entire year. For Shiloh, this is:
Return on Assets = $200,000 = 18.18%
So the traditional formula is not truly reflective of the actual return on investments. This is very important to consider especially if the business is seasonal in nature or recently acquired assets due to leverage or the sale of equity. Let’s look at Shiloh again. But this time the business borrows $200,000 to purchase a new truck for $100,000 and additional inventory of $100,000. Using the traditional formula and restricting the assets to the beginning balance, the result doesn’t change. But now, let’s use the average method as described above. Here is the beginning and ending balance sheets.
ASSETS Jan.1 Dec. 31
Cash $150,000 $250,000
Inventory 650,000 800,000
Fixed 200,000 350,000
Total Assets $1,000,000 $1,400,000
LIABILITIES $300,000 $500,000
EQUITY 700,000 900,000
Total Liabilities & Equity $1,000,000 $1,400,000
As before, earnings of $200,000 increases equity from $700k to $900k. Assets increased $400k due to $200k from earnings and $200k due to the loan. Now the formula under the average method results in:
Return on Assets = $200,000 = 16.67%
$1,200,000 (average for the year)
So growth entities driven by either earnings, leverage or sale of equity (more stock, capital investment or additional partners) can distort the results of this ratio. The results are also skewed if the earnings go negative (losses). Think about this for a moment, when earnings are negative, assets are consumed to cover these losses.
Not only do asset changes affect the final result, so do non-performing assets.
Non-performing assets are generally investments made by a business for a future purpose or as an offset for a liability. The future purpose can include expansion of business, a reserve of funds for economic recession or a legal requirement (patent, copyright, contractual obligation). Offsets to a liability are generally legal compliance mandated by a contractual agreement such as funding for a retirement account, contract compliance as seen in construction, life insurance cash value or bond issues. To illustrate, look at this detailed balance sheet and see if you can identify non-performing assets.
OLD DOMINION CONSTRUCTION INC.
December 31, 2016
– Cash $2,983,216
– Accounts Receivable 908,209
– Construction in Process (CIP) 8,306,914
– Contract Deposits 742,800
– Prepaids 114,309
Sub-Total Current Assets $13,055,448
Fixed Assets 9,201,331
. – Key Man Policies $207,414
– Bond Set-Asides 1,302,710
– Escrowed Funds 614,222
– Land for Future Development 561,772
Sub-Total Other Assets 2,686,118
Total Assets $24,942,897
– Accounts Payable $806,411
– Accruals 414,653
– Billings in Excess 6,343,381
– Contracts (Deferred) 955,000
– Other 402,006
Sub-Total Current Liabilities $8,921,451
Long-Term Liabilities 6,307,292
Total Liabilities 15,228,743
EQUITY (Current Earnings of $910,209) 9,714,154
Total Liabilities and Equity $24,942,897
The construction industry uses the completed contract or percentage of completion method to account for its earnings. The construction in process is actual work completed to date offset by any billings (in current liabilities) to date. So in effect, $1,963,533 of the $8,306,914 ($8,306,914 – $6,643,381) from construction in process in current assets is a legitimate asset for this formula. $6,343,381 has already been billed on the contracts for construction, so in effect this $6.3 Million is a non-performing asset. Another is contract deposits that Old Dominion made for future delivery of materials, performance or some other obligation that has nothing to do with earnings in 2016.
Further down in Other Assets the following are non-performing assets:
A) Bond Set Asides – Cash held with a trustee to pay the balance for a long-term liability in the future.
B) Land for Future Development – Land purchased for use in the future does not contribute to earnings in the current year.
Both key man life insurance and escrowed monies actually contributed to earnings in 2016. How so? The key man policy was an incentive to retain certain employees (project managers) during the year, thus it is an asset necessary to earn money in 2016. Life insurance on owners is generally used to address termination issues and not current earnings. Escrowed funds in construction are very similar to warranty funds to fix or make good on existing contracts so they affect current earnings. Given this, active assets equal $15,992,234 as follows:
Given the above, what is the return on assets all inclusive and net of non-performing assets? Let’s do the math.
All Assets W/O Non-Performing Assets
Asset Value on 12/31/16 $24,942,897 $15,992,234
Less Current Earnings (910,209) (910,209)
Asset Balance on 01/01/16 $24,032,209 $15,082,025 Note ‘A’
Note ‘A’ – Assumes no liabilities or equity increases to purchase additional assets in 2016.
Traditional W/O Non-Performing Assets
Return on Assets = $910,209 $910,209
= 3.79% 6.03%
There is a significant difference in the return on assets result when considering non-performing assets. This is rather an important comparative point when analyzing two similar companies in the same economic sector. Go back to the purpose of the return on assets ratio; it is designed to measure efficient utilization of resources, active resources, not all resources. Many results will not be as extreme as the illustration above; however, a user can expect upwards of 10% shifts in the outcome if exclusion of non-performing assets is exercised in the formula.
Another variable to consider is depreciation.
Depreciation’s Effect with Return on Assets
The formula is pure if depreciation is not included in the calculation of profit. In accounting, depreciation is an allocation of the capital expenditure for a fixed asset as an assignment of value decrease of the original cost basis [Article – Basis] as an expense with the determination of net profit. In effect it decreases the value of fixed assets and decreases the net profit. The mathematical outcome is almost always unfavorable with the result as the likelihood of a true equal ratio of the numerator (net profit)/denominator (asset value) is remote. To illustrate, look at a simple comparison for this company.
Return on Assets Report
Assets on 12/31/16 $6,209,403
Net Profit for 2016 $707,417
Depreciation for 2016 501,801
Return on Assets Traditional Method
Assets on 12/31/16 $6,209,403
Net Profit (707,417)
Assets on 01/01/16 $5,501,986
Return on Assets = $707,417 = 12.86%
Return on Assets Adjusted for Depreciation
Assets on 12/31/16 $6,209,403
Net Profit (707,417)
Asset Value on 01/01/16 $6,003,787
Profit for 2016 $707,417
Add Back Depreciation Taken as an Expense 501,801
Adjusted Profit B/F Depreciation $1,209,218
Return on Assets = $1,209,218 = 20.14%
Notice depreciation affects both the numerator and the denominator. The assets at year end include the increase from profits earned and the fact depreciation taken during the year reduced the overall assets value at year end. To determine the correct beginning balance, depreciation must be added back.
What this illustration demonstrates is that depreciation greatly affects the formula because both the numerator and denominator change, i.e. increase. However, the numerator increases at a disproportionately greater rate because the values are not related to the same degree.
The last variable that greatly impacts the formula is an intangible asset.
Intangible assets [Article – Intangible Assets] are non physical assets and include:
* Financing Costs
* Research and Development
* Contract Rights
The principles of accounting were traditionally conceptualized with fixed assets in mind. Intangible assets added a new dynamic to these concepts. Intangible assets have increasingly become a factor on balance sheets especially in the recent 30 years due to technological innovation. More and more value is assigned to intellectual property and not real property. This change is impacting all the traditional notions of calculating business ratios.
Unlike physical assets, intangible assets use amortization to allocate the acquisition costs to the income statement. There are several factors impacting the allocation models such as:
1) Change in Technology – Technological advances have shorter life cycles than physical assets as new software or hardware make relatively recent discoveries obsolete.
2) Consumer Loyalty – Social Media greatly impacts duration of trends. This reduces the life expectancy of goodwill.
3) Speed of Development – New drugs are developed quicker due to technology advances shortening the life cycle for actual marketable pharmaceuticals affecting the amortization schedule for research and development costs.
Amortization is similar to depreciation when determining return on assets. For those industries exercising amortization as a significant cost on the financial statements, the ending assets balance must be adjusted for amortization along with the net profit at year end.
Even when the user adjusts for asset changes, non-performing assets, depreciation and amortization the return on assets ratio is premised on a relatively stable industry. It can work well with growth rates of less than 3%. But high growth rates wreak havoc on the formula.
High Growth Rates
In business growth is often the most sought after characteristic. Increased sales, market share and ultimately profit are the most desired results. It is how a business is measured. Growth feeds value change and this value change is commonly found in an increasing stock price. One of the ratios used to evaluate stock price is return on assets.
Typically the net profit at year end is a result of not only the beginning assets balance but the investment in additional assets throughout the year. To get the true growth rate related to beginning assets, any net profit generated by the additional assets must be eliminated in order to ascertain the profit generated by the original asset balances. There are several tools available. These include linear and selective elimination along with gross margin adjustment.
Linear elimination assumes that the additional growth mirrors existing assets and works well with relatively stable markets such as consumer goods, service industries and real estate. The actual price for the new product or service isn’t significantly greater or different than that which existed in prior years. It becomes relatively simple to create two ratios, one being the return on assets for original assets and another for return on assets for new assets. Here is an example:
Martinos owned 17 grocery stores at the end of 2015 and added two new stores in 2016. Here are Martinos balance sheets and income statements for both years.
The return on assets was 2.66% (($992,000/($38,207,400 – $992,000)) in 2015. Martinos makes no adjustments for asset issues (changes, depreciation, non-performing assets and amortization) in determining return on assets. Based on the information above and without adjusting for growth, the return on assets for 2016 is:
Return on Assets = $1,107,900 = 2.90%
There is a big increase and would appear that Martinos is doing very well. But now let’s adjust in a linear fashion for growth. Typically the revenue growth is adjusted. In Martinos case, revenue grew 14.5%. So lets adjust all factors by the revenue growth. The key is that revenue growth includes the traditional expected revenue growth from the prior period assets in accordance with the return on assets, i.e. 2.66%. So in reality, of the $44,800,000 of revenue growth, about 18.2% (2.66%/14.5% total growth) relates to prior existing assets. This equals $8,153,600. Given this new sales are approximately $36,646,400. This same formula is done each line of the summary income statement. Here are the results:
Changes 2016 Original Assets New Assets
Revenues $44,800,000 $8,153,600 $36,646,400
Cost of Goods Sold 44,419,000 8,084,258 36,334,742
Gross Margin 381,000 69,342 311,658
Expenses 633,000 115,206 517,794
Taxes (397,900) (66,958) (600,942)
Net Profit $115,900 $21,094 $94,806
This means that the original assets of $38,207,400 generated a profit of $1,013,094 ($992,000 + $21,094) for a return on assets of 2.66%. In effect, the linear method holds original assets at a linear stable value to calculate the return on assets for assets associated with new assets.
New assets grew as follows:
Total Asset Growth $10,709,100
Less: Net Profit in 2016 (1,107,900)
Increase in Assets $9,601,200
Return on New Assets = $94,806 Net Profit Assigned to New Assets from Above
$9,601,200 New Assets
Return on New Assets = .987%
If Martinos averages the assets for the new stores, the return on assets will double to 1.97%. Take note of what is happening here, in the aggregate it appears that Martinos has a 2.9% growth rate weighted by the original assets at 2.66% and some marginal increase related to the additional assets. In reality, a very easy and quick solution is to take the increase in new assets and average them for the year, i.e. $4,800,600 and add them to the beginning balance of $38,207,400. Then calculate return on assets as follows:
This makes sense as the new assets are weighting down the linear growth of original assets (a 1.97% average growth rate for new assets in comparison to a 2.66% rate for original assets). The 2.57% rate is much more accurate than the 2.9% rate determined using the traditional method.
Another method to separate high growth rate issues from normal operations in determining return on assets is the selective elimination tool. With this method, the new assets net profit is separated from existing assets by utilizing accounting methods traditionally found in the respective industries. In retail, new store sales and costs are separated from the total to determine the net profit generated by the original assets. Other accounting tools include class accounting [Article – Class Accounting], project (job) costing and item tracking. The end result is ascertaining sales and costs related to the original assets and not the new growth profit generated by the new assets.
Gross Margin Adjustment
A third option is similar to the linear method except the whole formula centers on the gross margin. The theory is straight forward, the law of large numbers (actuarial science) states that a value will tend towards normalcy in a larger sample of data. In 2015, the gross margin was 8.77% of sales. Given $308,900,000 of sales, this average should be close in 2016. However, in 2016, the gross profit margin is 7.77%. This is a significant decrease and must be attributable to the new store sales. In effect, the cost to operate the new stores is much more expensive than existing stores. This would make sense. Look at the average asset cost per store between the old stores and the new stores:
The marginal asset value for the two new stores is $9,601,200. The cost of assets per store is more than double the value of existing asset value per store. Using the return on assets formula, if the denominator doubles, the result will be cut in half. Thus the more than significant decrease in the total gross profit margin for the aggregate.
In a highly stable economic industry such as food sales, the marginal cost per dollar for new stores will always be greater than existing stores. Thus the return on assets will decrease in the aggregate.
In general, the financial statements released to the public do not provide the additional information necessary to adjust or determine an accurate return on assets in a high growth industry. This is why it is important to set parameters for this particular ratio.
Setting a Relevant Range for Return on Assets
A relevant range refers to an expected result based on actuarial science. If you read the financial results as reported by major companies, they always talk in small percentages. For example, retail will always refer to 1 – 2% changes in sales volume from one quarter to the next or for the same store comparisons from one year to the next. When these values change more than 3% in either direction, the news is considered significant. In many situations the results of this magnitude call for firings or acclaim for the management team. So any deviation of 3% in any direction over a prior year should raise eyebrows. Therefore the relevant range is approximately 97% to 103% of a prior year results. Any change in excess is cause for concern. To illustrate let’s look at this example.
Dakota Mining is a surface mining company producing lead, uranium and other highly valuable minerals. It has operations from Missouri throughout the Midwest and as far north as Alaska. The historical return on assets has been 7.83%. In 2016, Dakota acquired a new mine in Montana that uses a new technology which increases the final mineral removal rate about 7%. The acquisition cost was $1.5 Billion dollars for a total increase of 17% in assets (from $8.75 Billion to $10.25 Billion). The net profit increased to $868,175,000 during 2016. The return on assets equals:
$868,175,000 = 8.47%
Note: The new mine was purchased starting January 1 of the new year; so the total asset value equals the beginning balance consisting of the prior year ending balance plus the purchase of the new mine.
The relevant range is 7.6% to 8.06% given the 3% rule.
This new technology in mining makes a big difference in the overall return on assets. If this technology could be applied to all mining processes, imagine the overall profitability and return on assets. For an investor, this could dramatically increase the value per share in the market.
Without a relevant range it would be really impossible to determine if the return on assets was good or bad in comparison to prior periods. The relevant range is only effective with large companies. Other tools must be considered for small business with less than $250 Million in sales volume per year. These adjusting tools include:
* Use of elimination methods
* Alternative return on asset ratios such as using gross profit against assets instead of net profit against assets
* EBITDA to Asset Ratio comparison
* Ignoring the return on assets ratio entirely
The relevant range has another important attribute; as the value tends beyond the relevant range red flags should go up in the mind of the ratio user. The law of large numbers tells statisticians that any deviation beyond the range is cause for concern. Think about this for a moment, in order to go 3% below the expected norm, not one but several managers would have to underperform; in reality they would almost have to sit down and do nothing. Think of Dakota Mining, they are operating mines 24 hours a day, 6 days a week across tens of mines meaning there are over 100 plant production managers. To deviate to a lower level, these guys would almost have to conspire to reduce output. Any deviation beyond the relevant range demands the user of this ratio to investigate the underlying cause.
With the much greater than expected return on the assets than anticipated there must be something more than the technology used at one mine. A prudent investor would research market price of the minerals sold, production output, use of new equipment or labor efficiencies that may have contributed to this significant gain in return on assets. The research will identify if the trends can be maintained or if they are temporary.
Summary – Return on Assets
The return on assets ratio is used to identify the efficient use of active assets. It is simply the net profit divided by the beginning balance of all assets. To increase the accuracy of the ratio assets should be adjusted for changes in assets, non-performing assets, depreciation and amortization. High growth rate companies should delineate the return on assets for original ongoing assets and assets associated with the recent earnings for growth sectors (divisions of the company).
Finally it is important to set a relevant range for the results with the return on assets. Reasonable deviations are within 3% in either direction of the expected amount. Any change greater than 3% warrants questions related to market price, production, technology and labor. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.