© 2000 John Petroff
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© 2000 John Petroff |
3)-ROA
The standard and general evaluation of profitability is based on return on investment ROI calculation as net profit after tax PAT divided by total investment
ROI = PAT / Investment
What investment should be in the denominator? It can be equity, debt, all funds provided, total assets or only tangible assets. Depending on how investment is defined different rates of return on investment are calculated. The first and most common definition of investment is the total of all assets put to use to produce such earnings. ROI then becomes ROA, i.e. return on asset, or return on total asset TA to be precise
ROA or ROTA = PAT / TA
This ratio reveals how efficiently the assets of the company are used to generate profits.
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For this example we take Lucent Technologies. From Table T-6.7, Lucent Technology Income Statement, we take the profit after tax for 1999 of $ 4,766 millions, and from Table T-6.8, Lucent Technology Balance Sheets, we take the total assets of $ 38,775 millions. The resulting return on total assets is ROA = 4,766 / 38,775 = 0.1229 or 12% which can be found in Table T-5.19 - Lucent Technology - Ratios. |
Some textbooks recommend to calculate return on investment in general, and return on total assets in particular, using average investment, and not end of year balance. The reason is that the income reported has been generated over the entire twelve months and it would be incorrect to assume that the same amount of assets has been put to use throughout the twelve months. This correction is especially important if the company is known to have acquired or sold major productive facilities during the year. The return on average total assets is
ROAav = PATt / ((TAt + TAt-1)/2)
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To illustrate the importance of averaging total assets, we take Merck's results in 1993. As shown in Table T-6.3, Merck & Co., Inc.. Income Statements, profit after tax was $ 2,166 millions in 1993. Total assets were $ 11,086 millions at December 31, 1992 and $ 19,927 millions at December 31, 1993. Return on average total assets is ROAav = 2,166 / ((19,927 + 11,086)/2) = 2,166 / 15,506 = 0.1396 or 14% Whereas, if the return on total assets were calculated with end of year figure only, it would be ROA = 2,166 / 19,927 = 0.1087 or 11% The number shown by Merck for its return on assets is 14% in its statistical summary. |
Although calculating with averaged investment in denominator is more accurate and logical, it is not always done. One reason is that investment measured by total assets usually does not change much from year to year. In addition, averaging with ending and beginning amounts only ignores changes that may have taken place during the year. The major reason is that averaging investment reduces the number of observations (sometimes to just one if only two years of balance sheet data are presented in an annual report). Having some historical pattern of behavior of return on investment for an outside analyst is more important that the gain in mathematical accuracy. For an inside analyst with every last piece of data at the figure tips, there is no question that averaging is recommended. A quick investigation of a small sample of annual reports where ratios are presented, revealed that some companies average investment and some companies do not. For instance, Merck does, but Dow Chemical and Lucent Technologies do not. Except where averaging is necessary to avoid a distortion (as in the example above), in the remaining of this writing, return on investment will be presented without averaging.
More insight can be gained by breaking down the ratio into net profit margin and asset turnover in a DuPont approach (introduced for the assessment of affiliates in Chapter 4 Section G-3) . The first part is net profit margin, and indicates how well costs are controlled. The second is total assets turnover, and shows the ability of the firm to manufacture and market the volume of sales.
ROTA = (PAT / Sales) * ( Sales / TA)
ROTA = net profit margin * total assets turnover
Net profit margin will be studied in next section and a great deal more later in this chapter and total assets turnover was looked at in Chapter 10.
ROA suffers from the distortions in the balance sheet, that were discussed at great length in Chapter 10. One very common correction is to take out intangible and unproductive assets from total assets. One will recall that intangible assets are goodwill, initial formation costs, patents, copyrights and various other rights which are amortized over a long period of time, and may not directly contribute much to generating revenue any more if they have been acquired a long time ago. Whereas unproductive assets are excess inventory and unused plant capacity. Isolating the portion of inventory that is excessive, and the amounts corresponding to the fixed assets that are not used, is only possible for an analyst inside the company. For outsiders, the latter correction is rarely done if the balance sheet or notes to financial statements do not give those numbers. Thus the only correction that is common, is to restate the denominator as tangible assets TTA. The ratio is then known as return on tangible assets ROAt:
ROAt = PAT / TTA
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Let us take Merck to calculate this ratio. First we calculate return on total assets by taking net profit after tax of $ 5,248 millions for 1998 from Table T-6.3, Merck & Co., Inc. Income Statement, and total assets $ 31,853 millions from Table T-6.4, Merck & Co., Inc Balance Sheets 1997-98. This gives a return on total assets of ROTA = 5,248 / 31,853 = 0.1647 or 16% as can be noted in Table T-5.17, Merck & Co., Inc Ratios. Now, let us take intangible assets out of total assets. For Merck in 1999, goodwill and other intangibles amount to $ 8,287 shown in Table T-6.4: this gives tangible total assets of $ 23,566 millions. Return on tangible assets is ROAt = 5,248 / 23,566 = 0.2227 or 22% |
One adjustment occasionally found for the numerator is to restate it as profit before tax rather than after tax. The reason was mentioned previously: taxes are often affected by special circumstances experienced by companies such as loss carryforward, various tax incentives and deferments (see for instance the discussion of effective tax rate of Lucent Technologies in next section). When comparing companies, differences in effective tax rate would bring distortions to profit after tax. It is just so simple to avoid these distortions by using profit before tax PBT which always appears in an income statement. This is the format used by Robert Morris Associates in their "Annual Statements Studies" (which are specifically designed to allow comparison with a large number of diverse companies). The before tax return on total assets ROTAb is then
ROTAb = PBT / TA
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We continue with Merck to demonstrate the use of this ratio. We take profit before tax of $ 8,133 millions for 1998 from Table T-6.3, Merck & Co., Inc. Income Statement, and as before, total assets $ 31,853 millions from Table T-6.4 . The return on total assets becomes ROTAb = 8,133 / 31,853 = 0.2553 or 26% shown also in Table T-5.17, Merck & Co., Inc Ratios. This is certainly a statistic of a very profitable company. To determine just how profitable that is, we compare to companies in the same industry (i.e. Manufacturing - Pharmaceutical preparations SIC# 2834). Industry competitor have an average ROTAb of 10%, according to RMA. This shows that Merck is doing very well. In fact, Merck's 25% return is higher than the highest quartile for the largest companies of 21.7%. In addition, Table T-5.17 shows that Merck's performance the previous year was just as good with ROTAb of 25%. But, an analyst must go behind appearances. It was observed earlier that Merck had a gain from termination of a joint operation of an amount of $ 2,600 millions which was not shown as an extraordinary item, but merely as other income (or, more precisely as a negative item of expense). If we deduct this gain from the reported profit before tax, ROTAb comes down to a more earthly 17% (i.e. 5,533/31,853). |
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We now return to Lucent Technologies for another demonstration of the use of this ratio. As before, we take the amount for total assets of $ 38,775 millions from Table T-6.8, Lucent Technology Balance Sheets. We take profit before tax of $ 5,443 millions from Table T-6.7, Lucent Technology Income Statement. Before tax return on total assets is ROTAb = 5,443 / 38,775 = 0.1404 or 14% as shown in Table T-5.19, Lucent Technology Ratios. First, we note that this ratio is not much larger than ROA calculated after tax shown above to be 12%: the increase is a slim 2% (compared to the significant increase of 10% in Merck's returns, from 16% to 26%). The reason is that profit after tax includes the cumulative effect of accounting changes of $ 1,308 millions net of tax (i.e. an extraordinary item mentioned in an earlier example). Now, we want to judge how good Lucent Technologies' ROTAb of 14% is. We compare it to the telephone communications industry (SIC# 4813) in RMA, which shows an average PBT/TA of 8.4%. Lucent Technologies' 14% is clearly much better; it approaches the upper quartile of 18.2% for the largest firms in the industry. Moreover, Lucent Technologies is not just in telephone communications, but also in other communications services: that industry (SIC# 4899) has an overall average ROTAb of only 4% for 1999, a median of 2.6% and an upper quartile of 10.7% for the largest firms. Clearly Lucent Technologies has a better performance. However, looking back in Table T-5.19, we observe that the previous year performance is far from being as brilliant with ROTAb of 9%. This points to the need to investigate if Lucent Technologies 1999 performance is out of the ordinary. |
Defining ROA with profit before tax rather than after tax is far from being universal. It suffers from the deficiency that balance sheet assets are all stated in a unit of after tax dollars, which is inconsistent with the before tax dollars of profit before tax.
Another modification of ROA numerator is to add back interest expense I. ROA is called return on total funds provided ROTFP, and is restated either before tax
ROTFPb = (PBT + I) / TA = EBIT / TA
or after tax
The purpose of this version of return on total assets is to recognize that the funds used to carry company's asset come from both borrowed funds and equity, and that the portion of operating profit going to lenders, i.e. interest, has been deducted in arriving at net profit, and must therefore be added back. One will observe that when interest is added to profit after tax, it is converted to an after tax equivalent so that all items of the numerator are stated in a consistent manner.
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For this ratio, we turn to Bell Atlantic. We take profit after tax of $ 2,965 millions, profit before tax of $ 4,999 millions and interest expense of $ 1,335 millions from Table T-6.5, Bell Atlantic Corporation Income Statement (from which we also note that the effective income tax rate is 40%, or 2,008/4,999), and total assets of $ 55,143 millions from Table T- 6.6, Bell Atlantic Corporation Balance Sheets. First we calculate return on total funds provided using earning before interest and taxes ROTFPb = (4,999 + 1,335) / 55,143 = 6,334 / 55,143 = 0.1148 or 11% This is a statistic that can be used for internal purposes, but has little meaning for investors and lenders. Now let us calculate the after tax return on total assets, with interest after tax equivalent added to profit after tax. This adjusted return on total funds provided is ROTFPa = (2,965 + 1,335*(1-0.04)) / 55,143 = (2,965 + 801) / 55,143 = 0.06829 or 7% Compared to ROA stated as profit after tax / total assets (i.e. without interests expense added in) which is only 5% as shown in Table T-5.18, Bell Atlantic Corporation Ratios, this return on total funds provided of 7% seems much closer to actual market yields and more meaningful. For instance, we observe in note #9 to financial statements that Bell Atlantic's yields on debt are much higher than 5%. |
A further improvement in matching funds used with income generated is to exclude from the funds used current liabilities which are not financing productive assets but working capital. Investment in the denominator is then the sum of long term debt LTD and equity E (also called permanent funds). The ratio is thus called return on permanent funds ROPF. Once again, the ratio can be either before tax
ROPFb = EBIT / (LTD + E)
or after tax
ROPFa = (PAT + I*(1-t)) / (LTD + E)
Care must be exercised to include all forms of debt, but ignore non-current liabilities which do not really constitute a source of borrowing. In the latter, provisions or deferred income tax would be examples because they do not constitute claims by any outside party and may never have to be paid. In the former, preferred stock, minority interests and stock of subsidiary would be part of funds provided to the company for an indefinite period of time. (This issue was already raised in Chapter 11 in another context. Inclusion of post-retirement benefits is questionable. Yet, if the company had to pay out these future claims into an autonomous fund, it would have to borrow an equivalent amount money. Still, post-retirement benefits are usually not included in permanent funds.)
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We continue with Bell Atlantic for these ratios. We take the same numbers for profit after tax of $ 2,965 millions, profit before tax of $ 4,999 millions and interest expense of $ 1,335 millions from Table T-6.5, Bell Atlantic Corporation Income Statement. And from Table T- 6.6, Bell Atlantic Corporation Balance Sheets, we take long term debt of $ 17,646 millions and equity of $13,025 millions, to which we add minority interest of $ 330 millions and preferred stock of subsidiary of $ 200 millions. The before tax return on permanent funds is ROPFb = (4,999 + 1,345) / (17,646 + 13,025 + 330 + 200) = 6,334 / 31,201 = 0.2030 or 20% Just as in the previous calculation this return of 20% does not have an immediate application other than for internal evaluation. Now we calculate the after tax return on permanent funds with after tax interest equivalent added to profit after tax: ROPFa = (2,965 + 1,335*(1-0.04)) / 31,201 = 3,766 / 31,201 = 0.1207 or 12% This ratio still seems high compared to actual yields paid; a possible reason is that short term debt is excluded from the denominator. |
See review questions Q-13B3.1 through Q-13B3.12.
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