This Return On assets post is the fifth post in a series of articles about financial ratios.
Which Company is Worth More?
Let us assume you are interested in purchasing a company that makes bicycles here in the USA. You have narrowed your search to two companies. Remarkably, net profits from both companies are almost identical, varying by only $2,500. Company One has net profits of $235,000 and Company Two has profits of $237,500. Each company is asking $1,000,000 in an asset only sale.
You are confused, which should you buy?
The Return On Assets Ratio
One way of sorting the wheat from the chaff in this example is to look at Return On Assets. Return on Assets determines how efficiently a company is using its assets to produce profits.
Often, asset heavy companies such as an airline, produce low profits on large amounts of assets. Their capital intensive nature demands large investment in assets before any profits are seen. Less capital intensive companies, such as a bagel shop, may produce large profits on a small amount of assets.
So Let’s Examine the Targets
In the case above, let’s assume average assets for 2013 (beginning year total assets + ending year total assets from the balance sheet divided by 2) for Company One is $560,000 and Company Two is $730,000. Return On Assets for Company One is 0.42. Return On Assets for Company Two is 0.33.
Company One had a slightly lower net profit but more efficiently used its assets to manufacture those profits. All other factors being equal, and they never are, Company One should be able to expand its manufacturing base more profitably than Company Two. More importantly, it demonstrates that management in Company One is able to wring more profit out of less capital than Company Two.
Does that mean Company One is the one to purchase? Well that depends.
If the purchaser had little manufacturing or business experience, and was leaving existing management in place, Company One would be a good choice for them.
The efficiency is there and if it remains, it would be an acceptable price to pay for the company at 4.26 times annual profits.
However, if the purchaser was a skilled company manager who was confident he could bring the Return On Assets of Company Two into line with Company One, then Company Two would be the one to buy. If he were successful in doing so, Company Two would then, all other things being equal, produce profits of $306,000. That would bring the price per earnings down to 3.27.
In other words, if the new owner could bring the Return On Assets of Company Two into line with Company One they would make more profits per dollar invested in the purchase.
What Else is the Return On Assets Ratio Good For?
Large companies are continually comparing their Return On Assets to those of their competitors to determine whether they are more or less efficient in the use of their assets.
The formula is also helpful in determining whether to purchase a building to house the company versus renting one. In general, if the Return On Assets on the building being purchased is reasonably close to the company’s own Return On Assets, the purchase of the building makes good sense financially.
However, there are usually other considerations at play besides Return On Assets, such as securing the ability to remain in a desirable location indefinitely, hedging against rent increases, ability to modify the space significantly to future purposes, etc.
As a humorous aside, I once was evaluating a customer for a loan. He had a well regarded and highly profitable business. He took most of the profits though, and invested them in investment real estate. Upon analysis it was shown that he was making only 1% profit on his $2,000,000 investment real estate portfolio.
When I pointed out the miserable Return On Assets, and that he could have invested in a long term CD with a better return and less risk, he snapped that investing in real estate kept him out of tech stocks! In truth, he had lost a small fortune in tech stocks so there was a perverted logic. However, even investing in high quality bonds probably would have tripled or quadrupled his returns with less risk.
Using Return On Assets in evaluating the purchase of a business is only one tool. There are many factors and the issue becomes complicated easily. For that reason it is often advisable to seek the advice and counsel of experts in the process. A good consultant or consulting CPA can make a world of difference.
Prior Articles in this Series:
Can You Afford That Loan? The Debt Service Coverage Financial Ratio
Turn Baby Turn – Why Inventory Turns Matter – The Inventory Turn Ratio
Debt to Net Worth – The Pros and Cons of Leverage
The Current Ratio – What Does Your Financial Statement Actually Say??
Other Return On Assets Resources:
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