Saturday, February 9, 2013

Components of Return on Total Assets Equation


Components of Return on Total AssetsDecision Analysis
A1 Compute and analyze the components of return on total assets.

A company’s return on total assets Ratio reflecting operating efficiency; defined as net income divided by average total assets for the period; also called return on assets or return on investment. (or simply return on assets) is important in assessing financial performance. The return on total assets can be separated into two components, profit margin and total asset turnover, for additional analyses. Exhibit 15.9 shows how these two components determine return on total assets.

EXHIBIT 15.9Components of Return on Total Assets

Profit margin reflects the percent of net income in each dollar of net sales. Total asset turnover reflects a company’s ability to produce net sales from total assets. All companies desire a high return on total assets. By considering these two components, we can often discover strengths and weaknesses not revealed by return on total assets alone. This improves our ability to assess future performance and company strategy.

To illustrate, consider return on total assets and its components for Gap Inc. in Exhibit 15.10.
EXHIBIT 15.10Gap’s Components of Return on Total Assets

* Differences due to rounding.

At least three findings emerge. First, Gap’s return on total assets improved from 9.0% in 2007 to 12.6% in 2009. Second, total asset turnover has slightly improved over this period, from 1.84 to 1.89. Third, Gap’s profit margin steadily increased over this period, from 4.9% in 2007 to 6.66% in 2009. These components reveal the dual role of profit margin and total asset turnover in determining return on total assets. They also reveal that the driver of Gap’s recent improvement in return on total assets is not total asset turnover but profit margin.


Generally, if a company is to maintain or improve its return on total assets, it must meet any decline in either profit margin or total asset turnover with an increase in the other. If not, return on assets will decline. Companies consider these components in planning strategies. A component analysis can also reveal where a company is weak and where changes are needed, especially in a competitor analysis. If asset turnover is lower than the industry norm, for instance, a company should focus on raising asset turnover at least to the norm. The same applies to profit margin.

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