Every business with a Return on Asset Ratio below 1 is an inefficient business. The inefficiency lies in their inability to convert investments in assets into profits. If your ROA is less than 1 and you have high liabilities, you will have serious cash flow problems.
Your cash flow is tight because you fail to efficiently use the assets you pay to generate the profits that should cover your principal and interest payments. If this is the case for you, consider selling the underperforming asset to get out from under the debt obligation for an asset that isn’t earning its place in your business.
Overview
The sole purpose of business assets is to generate revenues and produce profits. One of the best measures of how well management does this is the Return on Asset Ratio (ROA). A Profitability Ratio that shows how well the company can convert its investments in assets into profits—whether funded by equity or debt.
ROA measures how efficiently a company manages its current and fixed assets to produce profits during a given period. The return is measured in “net profits earned” from all of the company’s assets, regardless of whether they were funded with debt or equity—whereas Return on Equity (ROE) is focused only on the owner’s investment (equity).
The formula for the Return on Asset Ratio is as follows:
Net Income / Total Assets
A ratio of 1 means that a company’s net profits equal the year’s average total assets. In other words, the company generates one dollar of profit for every dollar invested in assets.
Higher is Better: a positive ROA usually indicates an upward profit trend unless high accumulated depreciation exists, indicating a business that is good at making money on fully depreciated assets.
Lower is Worse: any ratio below 1 indicates that assets are inefficient in producing sales.
Nothing good in business is sustainable unless you consistently make the money you should. Businesses with poor asset returns are typically businesses with weak sales, low profitability, and tight cash flow. If your business trades the equivalent of a dollar for four quarters, you fail to convert your assets into sufficient profits to make money. Correct this by adopting the BusinessCPR™ Management System to help you improve your ability to convert your assets into higher sales and profits.