I don’t know how you can look at ROA and not get inspired. Watch my discussion!
VIDEO SUMMARY
Out of the hundreds of accounting ratios, I consider Return on Assets to be the most important. That might be a controversial statement, and some of you may disagree with me, but I am going to explain my reasons. There is a lot going on in this ratio that a lot of people do not realize. I am going to give you five main things you need to know about Return on Assets.
- Combines the financial statements. Let us start with the equation. Return on Assets is Net Income over Assets. Both these variables come from two different financial statements. Net Income comes from the Income Statement and Assets comes from the Balance Sheet. This ratio is basically combining both your financial statements into one ratio.
- Explains productivity. This ratio is the mathematical definition of productivity. You have net income, which is value created. Then you have the assets used to create that value. This is the income created from these assets. This shows us how effective we are at using our resources. Productivity is the heart of everything we do in business. Think about it. All activities in accounting and corporate finance are designed to understand productivity. This allows you to focus your business on areas that generate the most productivity. That adds the most value to society, and makes the most money.
- Combines other ratios. This is the really cool part. Return on Assets is mathematically the same as profit margin times asset turnover. We talked about these two ratios last week. When we multiply profit margin and asset turnover, sales cancels each other out, and you are left with Net Income over Assets. This is helpful, because it allows you to drill down and understand what is driving your productivity.
- Connects with Economics. This ratio tells you that your productivity is tied to the economic forces of supply and demand. We talked about this last week as well. Profit margin is driven by price, which we know is impacted by supply and demand. When you combine the ratios, profit margin is telling you the demand for your product and asset turnover is telling you how effectively you are servicing that demand. The main concept is that productivity is based on the economic value you create for society.
- It is better to have LESS assets. This is the biggest misconception in business. Someone who does not understand Return on Assets might think that you want to have as much money as possible. But in this ratio, when you increase your assets, that actually decreases your productivity. What you really want is to create the greatest amount of value from the least amount of assets. You want the least amount of money. For example, imagine you have someone with $1 Million in an interest bearing account that creates $100k per year. Now imagine someone else who only has $100k in a business that can take that money and generate $1 Million per year. The person with $100k is actually better off than the person with $1 Million. This is the whole game of business. You want to do more, with less. Your goal is to shrink the amount of assets you have, while increasing the income you generate from those assets. Stock investors look for this. They look for companies with high productivity.
So let’s recap. Return on Assets is Net Income over Assets.
- This ratio combines the Income Statement and Balance Sheet
- This ratio explains the productivity of your business
- This ratio combines profit margin and asset turnover
- This ratio connects with the economic concepts of supply and demand
- It is better to have less assets, because it increases productivity
There is a lot going on in this simple ratio. I want to end by talking about the big picture. We only have so many resources in society. Business is about figuring out how to allocate those resources in the most effective way. Businesses are different combinations of resources, whether it is people or inventory or cash in the bank. Your job is to identify what area your business can focus on that will generate the most productivity. The more assets you can put toward those areas of focus, the more value you will create.
I hope you understand how significant this ratio is. If there is one thing that economic history has taught us, it is that productivity always wins. What always happens is the world recognizes when value is created and money flows towards those areas of productivity. It may not happen immediately, it may not happen overnight, but productivity will eventually win out. When we look back on human history, we see a constant progression with every generation becoming more productive than the previous one. This is a really inspiring concept, because that means productivity is the great equalizer. It does not matter what your background, or what country you are from, or whether you have any money. All that matters is how much value you can create. And if you work hard, and create more value than anybody else, you will win out in the end. That is what we learn from Return on Assets.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.