What are ROI and ROA?

Return on investment (ROI) and return on assets(ROA) are both commonly used financial metrics that measure the efficiency of a company or investment. They’re two distinct ratios with different equations that are used for different purposes. As a corporate manager or analyst, you should know where to use either one and why.?

What is Return on Investment(ROI)

Return on investment (ROI) is a performance metric that calculates the profitability of an investment. ROI expresses the return on an investment relative to its cost as a ratio or percentage. You can calculate the ROI of an investment by dividing the investment’s return by its cost.?

For example, if you’ve invested $100 in the stock market and your stock appreciates to $110, meaning a $10 gain, and you sell it, your ROI is 10%.?

Investment cost/Investment return * 100 = 100/10 *100% = 10%

Why is ROI important for businesses

ROI is important for business because it’s a simple and effective way to calculate an investment’s profitability. You can use ROI for a variety of scenarios, such as?

• Calculating the profitability of a stock investment?
• Determining the profitability of a business acquisition?
• Calculating the return on a real estate transaction?

In every case, the ROI calculation is simple and easy to interpret.?

A positive ROI means an investment yields returns, while a negative one means an investment only incurred losses. So investors and businesspeople aim to invest only in ventures with positive ROIs.?

A larger ROI also naturally means a bigger return than a smaller one. So investors are better off choosing investments with a higher ROI than those with a lower one.?

What is a good ROI??

Generally, most professionals consider an ROI above 10.5% for stocks to be desirable. But what constitutes a high ROI for an investment depends on the industry and context.?

As an example, tech companies often have ROIs exceeding 25%, but it’s rare for an energy company to have an ROI exceeding 15%.?

Limitations of ROI Analysis

ROA analysis has the following limitations:?

1. ROI has difficult-to-identify parameters?

Calculating ROI is simple, but it’s not always easy to define profit and cost. For instance, do you use gross profit, profit after tax, or profit after tax and interest? Similarly, do you use the gross cost of an investment, the net book value, or the historical cost of assets??

Unsurprisingly, how you define profit and investment will provide you with significantly different results. Using the gross cost of investment and profit after tax and interest yields a lower ROI than using gross profit and net book value for investment.?

You’ll have to define what a meaningful ROI metric is for you.?

2. Different entities use different meanings?

The first limitation implies that different companies would use different ROIs, which is true. Different companies will use different accounting standards to calculate ROI. But without consistent accounting standards, you can’t meaningfully compare the ROIs of different investments or business ventures.?

3. A high ROI doesn’t guarantee a high-value business?

A high ROI indicates that a potential venture or investment is desirable, but it doesn’t guarantee it. It’s a mistake to only select investments with a high nominal ROI. You should also take into account the increase in business value an investment could have in the long term.?

Making decisions purely based on ROI can lead to sub-optimal resource allocation for a business. A company’s priority should be to increase its long-term value rather than preserve or increase an ROI statistic.?

4. ROI only calculates short-term profitability?

Following the previous limitation, ROI completely ignores long-term profitability. Instead, it’s entirely focused on short-term profitability since you only use an investment’s immediate cost and return. But an investment or business decision could have long-term consequences not reflected in an ROI calculation.

What is Return on Assets

Return on assets (ROA) calculates how profitable a business is relative to the assets it possesses. This metric is used by corporate managers and analysts to determine how efficiently a company uses its assets to generate profit.?

You can calculate ROA by dividing a company’s profits by its average assets and multiplying by 100 to express as a percentage.?

ROA= profits/ average assets *100%

For example, say company A generates $5,000 in profit annually and has $50,000 of assets. It would have an ROA of 10%.?

Naturally, a higher ROA means a business is more efficient at generating profit than a company with a lower one. What constitutes a high or low ROA for a business depends on many factors, including its industry. So it’s best to compare the ROAs of similar businesses in similar industries.?

Why is ROA important for business?

ROA is the simplest metric for measuring a company’s efficiency. It tells you how much a company generates from the assets it possesses. For that reason, it’s the easiest way to evaluate whether a company is profitable relative to similar businesses in its industry.?

Let’s say you have a choice between investing in one of two companies: A and B. Both are construction firms.?

A has an ROA of 10% and B has an ROA of 20%.?

Since both firms perform the same task and belong to the same industry, it’s meaningful to compare their ROAs.?

Firm B has a higher ROA than firm A. That means Firm B is likely more efficient than firm A. So an intelligent investor would choose to invest in firm B.?

What’s a good ROA??

Generally, a good ROA is at least higher than 5%. A 20% ROA is generally considered excellent. But it’s misleading to compare the ROAs of drastically different companies because they use their assets differently.??

For instance, an accounting firm has fewer assets on a balance sheet than a construction company. So an ROA analysis would state that an accounting firm is less efficient than a construction company.?

This would be inaccurate since accounting firms don’t heavily use their assets to generate revenue, while construction companies do.?

Limitation of ROA Analysis

While useful, an ROA analysis has the following limits.?

1. Incomparable across industries?

The biggest limitation of ROA analysis is that you can’t compare the ROA of different industries. That’s due to different industries having generally different asset bases.?

For example, the coal mining industry regularly reports ROAs in the 30-45% range, but the oil and gas production industry reports lower ROAs of 15-20%.?

So you can’t compare firms in the two industries. A high-performing Oil and gas company may have a lower ROA than a poorly performing Coal mining company.

2. Limited practical application?

Many analysts feel that an ROA analysis is only useful for banks and other financial institutions. The reason for this is that ROA is a very simplistic metric that’s only useful for comparing with similar data.?

Banks and financial institutions primarily use ROA because their balance sheets represent the real value of assets and liabilities. So they’re able to use it as a short-hand for figuring out which of their assets generate a sufficient return,?

3. ROA uses historical data?

The consequence of using historical data is that you can’t easily explain the trends in changing ROA. This is because ROA is calculated with historical data. So you won’t find an explanation of why your company’s ROA changed within the metric.?

4. ROA cannot identify which assets are high or low performing?

ROA reveals how efficiently a company uses its assets to generate revenue. But it cannot identify high vs low-performing assets. So the ROA of a company may be misleading if most of its profit is generated from a small percentage of its assets.?

Is ROA better than ROI??

Neither metric is ‘better’ than the other. Which one you should use depends on the context.?

ROI is better for measuring the return on an individual investment.

ROA is better for evaluating how efficiently an entire company is managed.?