The return on average assets measures the efficiency with which a business utilizes its assets to generate a profit. The calculation follows these steps:
- Derive the average assets by adding together the beginning and ending book values of all company assets, and dividing by two.
- Divide the average assets figure into the net income generated during the measurement period.
Management is usually considered to be doing a better job when it can produce a profit with a reduced asset base. However, an excessive reduction of assets can be detrimental to the health of a business. For example, management could decide to reduce the number of days that customers are allowed to pay on credit, which reduces the investment in accounts receivable, but may also drive away some customers.
The concept works best when comparing businesses within an industry, since each of these competitors probably requires roughly similar amounts of assets to generate a profit.
A problem with the return on average assets is that it assumes the beginning and ending asset figures are representative of the asset levels experienced on a daily basis, which is not necessarily the case.