Let’s take another look at the basic accounting equation:

total assets = total liabilities + shareholders’ equity

Total liabilities is just what is says: everything that the company says it owes, regardless of where it appears on the balance sheet. The point of using an ROE-type formula is to measure a company’s profitability by comparing its net income to its assets. The return on assets formula (ROA) does just that; it divides net income by total assets, which includes shareholder’s equity plus all borrowings.

return on assets = net income/total assets

ROA measures a company’s profits compared to its entire investment. Another advantage of using ROA to gauge profitability over ROE and ROC is its stability. Also, ROA can be calculated for companies with negative shareholder’s equity, a condition where liabilities exceed assets.

ROA is useful for analyzing competing companies in the same industry.

Besides for comparing competitive firms, ROA is useful for gauging the profitability of a company on an absolute basis. High ROA firms are more profitable than low ROA firms and the implied growth limitation described in the ROE section applies to ROA as well. High ROA firms can grow faster than low ROA firms without borrowing or selling additional shares to raise capital.

What’s a satisfactory return on assets? I ran a screen in early 2002 that listed the five-year average annual ROA for all companies that met the following requirements:

1. The companies were not in the utility, mining, real estate or oil exploration or oil-production industries. I excluded these because many firms in these industries report unusually high ROAs.

2. The market capitalization had to be greater than $500 million, the share price over $5, the trailing twelve months’ sales over $80 million and the after-tax TTM net income greater than $1 million. These requirements screened out very small companies, or companies without significant sales or earnings.

Only 1,339 companies passed those tests. Of the survivors, 543 reported five-year average ROAs of 7 percent or higher, 305 had ROAs of 10 percent or more, and only 144 showed 15 percent or higher ROAs.

Because ROA takes liabilities into account, and ROE doesn’t, a company’s ROE will always be higher than its ROA. The amount of debt and other liabilities determines the difference. Of the 1,339 companies checked, 616 sported ROEs of 15 percent or higher, and 338 reported ROEs of at least 20 percent.

Most money managers that I interviewed said that they required minimum 15 percent ROEs. You’d have to accept ROAs of less than 7 percent to choose from an equal size universe. Based on preliminary research, 7 percent ROA is acceptable, but 10 percent is desirable, and higher is better.

Marginal Return on Assets

Profitability margins reflect the returns on a company’s total investments without regard to the investment date. Some money managers gain insight by measuring the returns on the most recent investments. They do that by computing marginal return on equity, capital, or assets.

You can calculate the marginal return on assets by dividing the change in net income by the change in asset value over the period. To calculate the marginal ROA for the past year, calculate the year-over-year change in net income and divide it by the asset growth over the year.