 Return on Total Assets - Formula and Explanation

The word return on total assets is also known as the return on assets ratio. The ROTA ratio represents how efficiently a company is operating its resources to generate earnings.

It is a profitability ratio that interests both creditors and equity holders. The return on total assets differs from the income of a company to the total assets invested in it.

It is one of the most important ratios used to evaluate the profitability of a company.

Some other important profitability ratios such as return on equity, return on capital employed, gross margin ratio and net profit margin ratio.

## What is Return on Total Assets?

The return on total assets (ROTA) is a profitability ratio that measures how well a company is utilizing its assets to generate profits during the period.

The return on total assets ratio gauges a company's earnings before interest and taxes (EBIT) compared to the total net assets.

The figure EBIT is used instead of the net profit to focus on operating earnings without involving the impacts of corporate taxation or financing differences when distinguished to the related companies.

## Return on Total Assets Formula

The return on total assets formula is simple. The return on total assets is computed by dividing earnings before interest and taxes (EBIT) by its average total assets.

Returns on total assets = EBIT / Average Total Assets

## Earnings Before Interest and taxes:

The loan taken by the company is also used to finance the assets which in turn is used to generate profits.

Hence, the debt holders are also part of the company. From this perspective, the interest paid out also belongs to a stakeholder of the company.

Also, the company benefits in terms of paying fewer taxes when interest is paid out, this is called a 'tax shield'.

For these reasons, we need to add interest while calculating the return on total assets. The ROTA ratio can be defined as the outcome of profit margin and total asset turnover.

EBIT = Net Profit + Interest Expense + Taxes

## Average Total Assets:

ROA needs for the estimation of the company's average total assets because the total assets of the company can change over the period with new purchases of land, machinery, sale/buy of assets, inventory changes etc. for this reason, investors should calculate the average total assets instead of calculating the total assets for a period.

Average Total Assets = (Total Assets at beginning of Year + Total Assets at End of Year) / 2

## Return on Total Assets Example

Suppose, it is an ABC company. Here is some information about ABC company,

The balance sheet of ABC company as on 31.03.2019

Particular Amount
Non-current assets
Fixed assets 425,000
Long term investments 390,000
Total non-current assets 815,000
Current assets
Cash in hand 20,000
Bills receivable 50,000
Inventory 250,000
Prepaid expenses 100,000
Short term loans 200,000
Total current assets 620,000
Total assets 14,35,000
Equity
Share capital 600,000
Reserve 330,000
Total equity 930,000
Non-current liabilities
Debentures 200,000
Long-term loans 150,000
Total non-current liabilities 350,000
Current liabilities
Bills payable 50,000
Overdraft 100,000
Short-term loans 5,000
Total current liabilities 155,000
Total equity and liabilities 14,35,000

The income statement for the year ended on 31.03.2019

Particular Amount
Revenue 10,00,000
Others Income 500,000
Total Income 15,00,000
Expenses
Salaries 300,000
Finance Cost 150,000
Utilities 90,000
Inventory 210,000
Total Expenses 750,000
EBT 750,000
Tax @ 30% 225,000
Net Profit 525,000

EBIT = EBT + Finance Cost

EBIT = 750,000 + 150,000

EBIT = 900,000

In a nutshell, the return on total assets formula is given below:

Returns on total assets = EBIT / Average Total Assets

Return on total assets

= (900,000 / 14,35,000)

= 0.62 or 62%

The return on total assets of 62% means the ABC company made 62% of profit for each rupee in assets.

## Significance of Return on Total Assets

The return on total assets is a financial ratio that measures how effectively management can use assets to earn an adequate return for a company.

In percentage, the return on total assets estimates how much money is earned from each rupee invested into the company. The higher ROTA ratio is more favourable to the investors.

The return on total assets ratio is higher that indicates the company is more effectively utilizing its assets to generate a greater amount of earnings or profits. A positive return on total assets ratio may also reveal an upward trend in income as well.

The ratio is more useful and mostly used when comparing a company within a similar industry to get real pictures about the company and as many industries use assets differently.

For example, construction companies that use weighty and expensive equipment for their operations will have lower ROTA because their assets value boost over the period.

While IT companies use computers and servers for their business activities will have lower ROTA because the company uses portable assets.

## What are the limitations of Return on Total Assets?

The return on total assets has several limitations that investors should be aware of. The limitations are as follows:

1. A limitation of the ROTA measurement is that the denominator is executed from book values as opposed to market values.

This is a specific problem if a business has a vast investment in fixed assets that leads to a higher value than is implied by their recorded book values.

In that case, the return on total assets is higher than is the case, for the reason that the denominator is too low.

2. Another limitation of this ratio is that it does not focus on how assets were financed. If a company has a high amount of debt to purchase its assets.

The returns on total assets could be looking favourable, while the company may actually be having trouble with the interest payments.