CAN WE COMPARE ROA VS COST OF CAPITAL?

Can we….?

I don’t think so. The way Return on Assets is computed is mainly based on the net book value (=balance sheet book value or historical cost or a kind of mix between historical cost and fair value) of total assets minus current liabilities (excluding the portion of debt falling due in one year) or total net working capital plus net fixed assets. While, cost of capital is a market-value concept, that is a return on market-value-based assets.

It is also hard to compare between ROA of one company with ROA of another company, knowing that it is an accounting-based return or performance measurement, the difference in accounting treatment could lead to different ROA though the underlying operational performance could be the same.

Other thing, ROA is a part of ratio analysis, and as all ratios, it eliminates the size difference between one company with another company. ROA of 10% of one company with total assets (net of current liabilities, excl. debt portion due in one year) of US$ 10 million and ROA of 10% of another company of US$ 1 million, cannot be compared.

High ROA doesn’t tell us much as well, whether similar assets could be bought now and get as high as that ROA. How about low ROA? Again, it doesn’t mean that the assets could be better employed elsewhere.

To me, ROA is more useful for internal analysis to see the aspects of the business that could be improved, similar to that well-known Dupont analysis.

A strong inducement to sell debt is that the interest on debt is deductible as an expense for tax purposes. Even without the tax consideration, a firm might seek to use debt, which carries a fixed interest payment, to magnify the gains on equity. This is called trading on the equity.

#Return on Assets #Cost of Capital #ROA #Equity #Dupont Analysis #Financial analysis #Company performance #Business performance #Financial Statements