This tutorial carries on from our article last week looking at two key measures of management performance and in particular Return on Equity (ROE). The connection between ROE and Return on Total Assets (ROTA) is the foundation upon which ROTA provides for ROE. In effect ROTA provides the means that shareholders drive value from their investment. Through the efficient and economic utilization of the assets under its control, management therefore drive value for owners and their equity. In substance without proper and consistent returns being generated from assets there is little chance that owners will see an appropriate return on their investment.
ROTA is calculated by: Profits Before Interest and Tax (PBIT) / Total Assets (TA)
PBIT = operating profits of the firm before interest and tax is deducted. So this is operating revenues less operating expenses (including direct and indirect)
TA = current plus non-current assets
In reviewing the commentary around ROTA there are two schools of thought to which short assets to include in the total assets figure. In particular, only those current assets for which a charge in the use of funds is made in their acquisition. For example, inventory purchased through “free” creditor lines of credit would not be included. Where as inventory purchased through interest bearing overdrafts would.
This difference in approach would result in the former approach producing, all other things being equal, a higher return as the denominator to the fraction is a smaller figure.
We feel that this would be a rather misleading approach as the source of asset funding should be inclusive of all sources as this is a reflection of how effective management are in their sourcing of funds. For example, a firm that was able to better utilize non-interest bearing funding is generating a more positive return for its shareholders when compared to another firm utilizing interest bearing funds.
So the key components used in this measure of management performance are total costs (excluding interest incurred), total income (excluding interest received) over total assets employed.
Return on Total Assets (ROTA)
Below are statements of financial performance and position with the same format and figures we used when looking at ROE in our previous tutorial. The ROTA figure is always expressed as a percentage and as we have mentioned already it is a key measure in how efficient management are in the deployment of the firm’s assets and the return therefore generated.
Statement of Financial Performance
|Less: Interest Expense||20,000|
|Less: Income Tax||32,000|
|Less: Dividends Declared||24,000|
Statement of Financial Position
|Less: Current Liabilities||240,000|
PBIT = Profit Before Interest and Tax
PBT = Profit Before Tax
PAT = Profit After Tax
When compared to the ROE we calculated with the same figures, being 16.4%, the ROTA 14.0% reflects the leverage that owners achieve through the use of debt. A modest 2 percentage points can make a significant difference as the scale of the business increases.
Of course like any analysis the figure calculated and the conclusions drawn from it must be analyzed within context. The context in this sense means looking at both the longitudinal data series of the firm itself and the cross-sectional comparison with other firms within the sector and other comparable sectors. At the moment 14.0% means little to us in how well this firm’s management is performing.
And of course these comparisons are set within the context of the general economic conditions of the economy and the sector itself. One would expect, ceteris paribus, that as economic conditions improve so would returns on assets and equity. While as conditions deteriorate returns would track down in the same manner.
The performance of management, which this is a key measure of, is compared against what targets have been set and how the performance compared against similar firms and over previous years. Without this type of context performance is very difficult to measure and the figure itself means little. One only needs to see this in the media on a daily basis when a particular company’s profit is reported as $xxx million; often with inference of price gouging or monopolistic power or some stakeholder group demanding a greater slice of the action, for example employees. But the profit figure in-it-self means little when used in isolation. Is the $xxx million a growing or shrinking figure? Does it reflect a 50% ROTA or a 1% ROTA? How are comparable firms in the sector performing? Which profit was reported? A highly leveraged firm could well have a much better PBIT compared to a firm carrying little debt.