12. La Ratio ROA ROI

How is ROA Calculated?

Understanding ROA vs. ROE

• The Return on Assets (ROA) is often confused with Return on Equity (ROE), which measures net profit against equity contributions, such as 100 million from shareholders.

• ROA, representing the return on a total investment of 300 million, should not be calculated simply as net profit over total assets; this approach is incorrect.

Misconceptions in Calculation

• A hypothetical scenario illustrates that if machines are financed differently, it does not affect their operational efficiency or output.

• The speaker questions whether an asset performs better when purchased outright versus financed through debt, concluding that financing method does not inherently impact performance.

Correct Calculation Methodology

• The correct formula for calculating ROA involves using earnings before interest and taxes (EBIT), divided by the average total assets throughout the year.

• For example, starting with 300 million in assets and considering any additional purchases during the year leads to using average asset values for accurate calculations.

Example Scenarios

• In a case where EBIT is 40 million against an investment of 300 million, the resulting ROA would be approximately 13.3%, contrasting with a previously calculated ROE of 20%.

Comparative Analysis of Two Identical Companies

Hypothetical Company Structures

• An example introduces two identical companies: one operates normally while the other is based in a tax haven and fully equity-financed.

• The second company generates similar profits but avoids taxes entirely due to its location and financing structure.

Performance Evaluation

• Despite generating higher EBIT (40 million vs. 30 million), the first company's net profit appears lower due to tax obligations compared to the second company's zero tax liability.

Implications of Financing Decisions

• This scenario raises questions about who performed better: despite higher net income in one company due to favorable conditions, true performance should consider operational efficiency rather than financial structuring.

Key Variables for Business Viability

Importance of Adequate Returns

• A critical variable for assessing business viability includes ensuring adequate returns measured through metrics like ROE and ROA/ROI.

Contextualizing Returns Against Market Rates

• Adequate returns mean comparing ROE against prevailing market interest rates and evaluating whether ROA exceeds debt costs.

Lending Considerations

• Banks are unlikely to lend if the cost of debt surpasses potential returns indicated by ROA; thus understanding these relationships is crucial for securing financing.

Practical Interpretation of Metrics