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.
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