Return on assets (ROA) is defined as 
.
ROA is one of the most common performance measures. It mixes the income statement’s results with the balance sheet’s results, answering the question, “How good are we at producing wealth with our assets?”
As a measure, ROA has two drawbacks:
- It pays little attention to sales growth.
- It biases behavior towards the accumulation of equity.
When ROA is used alone, management pushes for increased profits while minimizing assets.
Because interest payments reduce profits, management avoids debt where possible.
Management is torn about increasing the size of the asset base. On the one hand, with assets in the denominator, any increase in assets makes it difficult to improve ROA. On the other, overall profits depend in part on sales volume. If we increase sales volume while holding ROS constant, the absolute profits must increase.
Management becomes cautious. When buying an asset, they must be confident that enough profit will flow from the investment to maintain or improve ROA. When funding the investment, they avoid debt, thereby limiting the size of the investment and increasing pressure to do stock issues.
In the end, assets grow slowly. Debt falls. Profits are retained. Stock is issued, but because there are no dividends, stock price stays flat.
Assets Minimally Increased To Emphasise ROA
| ASSETS | LIABILITIES & OWNER'S EQUITY | |||
| Cash | $4,000 | Accounts Payable | $8,400 | 7.0% |
| Accounts Receivable | $12,000 | Current Debt | $2,400 | 2.0% |
| Inventory | $16,000 | Long Term Debt | $15,600 | 13.0% |
| Total Current Assets | $32,000 | Total Liabilities | $26,400 | 22.0% |
| Plant and equipment | $134,000 | Common Stock | $39,600 | 33.0% |
| Accum. Depreciation | ($46,000) | Retained Earnings | $54,000 | 45.0% |
| Total Fixed Assets | $88,000 | Total Equity | $93,600 | 78.0% |
| Total Assets | $120,000 | Total Liab. & O. E. | $120,000 | 100.0% |
Implications
The implications for other performance measures include:
- ROE: Falls. Equity accumulates faster than profits increase.
- ROS: Should at least stay flat, and probably improves.
- Asset turnover: Should at least stay flat, and probably improves.
- Stock price: Stays flat. No dividends. Stock issues dilute stock. EPS stays flat.
- Market cap: Increases, although stock prices stay flat, there are more shares outstanding.
- Cumulative profit: Increases.
- Market share: Stays flat.
ROA pressures management to avoid risk, emphasize efficiency, and to improve incrementally profits.
Privately held companies often emphasize ROA.
Publicly held companies, however, would never use ROA alone for the same reasons they would not use ROS alone. It disappoints stockholders, who see no appreciation in their stock price, and it makes the company a takeover target. It has such an attractive mix of debt and equity that a corporate raider could buy the company using its own debt capacity.