Return on total assets definition
/What is the Return on Total Assets?
The return on total assets compares the earnings of a business to the total assets invested in it. The measure indicates whether management can effectively utilize assets to generate a reasonable return for a business, not including the effects of taxation or financing issues.
How to Use the Return on Total Assets
The return on total assets is useful for comparison purposes. For example, an outside analyst can compare the return on total assets of a number of competitors in the same industry to determine which one is reporting the most efficient asset usage in comparison to earnings. Internally, the concept can be used as the basis for a detailed investigation of which assets are being nonproductive and so should be disposed of. It can also lead to an examination of the working capital investment, to see if operating policies can be adjusted to minimize the amount of working capital.
In both cases, it is useful to track this measurement on a time line, to see how well management is using assets to generate earnings. A gradual decline in the measure is a strong indicator that management is not doing its job of enhancing company efficiency.
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How to Calculate Return on Total Assets
The calculation of the return on total assets is earnings before interest and taxes (EBIT), divided by the total assets figure listed on the balance sheet. The EBIT figure is used instead of net profits in order to focus attention on operating earnings. The formula is:
Earnings before interest and taxes ÷ Total assets = Return on total assets
The total assets figure is inclusive of contra accounts, which means that accumulated depreciation and the allowance for doubtful accounts are subtracted from the gross amount of assets on the balance sheet.
Example of Return on Total Assets
ABC International reports net profits of $100,000. This figure includes interest expense of $12,000 and income taxes of $28,000. When these two expenses are added back, the EBIT of the company is $140,000. The total assets figure for the company is $4,000,000. Therefore, the return on total assets is:
$140,000 EBIT ÷ $4,000,000 Total assets = 3.5% Return on total assets
Problems with the Return on Total Assets
A concern with this measurement is that the denominator is derived from book values, rather than market values. This is of particular concern when a business has a large investment in fixed assets that have a higher value than is indicated by their reported book values. In this case, the calculated return on total assets is higher than is really the case, since the denominator is too low.
Another concern with this measurement is that it does not focus on how assets were financed. If a business used high-cost debt to buy its assets, the return on total assets could be favorable, while the business is actually at risk of defaulting on the debt.
A further concern is that the measurement can be manipulated by leasing assets or outsourcing asset-intensive activities, rather than buying the assets outright. This removes assets from the denominator of the equation, resulting in an inordinately high return on total assets.