A measure of profitability for a firm engaging in operations selling merchandise in its stores to generate net income includes the rate of return on assets. Discuss the rate of return on assets

Answer 1

RATE OF RETURN ON ASSETS

The rate of return on assets (ROA) measures a firm's performance in using assets to generate net income independent of how the firm financed the acquisition of those assets. The rate of return on assets relates the results of operating performance to the investments (assets) of a firm without regard to how the firm financed those investments.

The calculation of ROA is as follows:

Net Income + Interest Expense Net of Income Tax Savings
ROA = -----------------------------------------------------------------------
Average Total Assets

ROA answers the question: how well has the firm done in conducting its operations independent of financing costs? The amount in the numerator of ROA excludes any interest expense on debt and distributions to shareholders. The calculation of the numerator amount begins with net income. If the measure of performance in the numerator is to exclude the costs of financing, then the analysis must add back the amount of interest expense because, in computing net income, the firm subtracts interest expense. Because firms can deduct interest expense in calculating taxable income, interest expense does not reduce after-tax net income by one dollar for each dollar of interest expense. Rather, each dollar of interest expense reduces after-tax net income by less than a dollar. Thus, to calculate the numerator of ROA (which measures performance independent of financing costs), the analyst adds back interest expense reduced by the income taxes that interest deductions save. The measure of investment for the denominator should reflect the average amount of assets in use during the yea, because ROA is computed for a year, . A crude but usually satisfactory figure for average total assets is one-half the sum of total assets at the beginning and at the end of the year.

ROA has particular relevance to the lenders, or creditors, of a firm. These creditors have a senior claim on net income and assets relative to common shareholders. Creditors receive their return via contractual interest payments. The firm typically pays these amounts before it makes payments, usually as dividends, to other suppliers of financing. When extending credit or providing debt financing to a firm, creditors want to be sure that the firm can generate a ROA from using the financing that exceeds its cost. Common shareholders find ROA useful in assessing financial leverage..