Why Do You Use Net Income to Calculate Return on Assets (ROA)?

You’ll learn why you pair Net Income with Return on Assets (ROA) in this lesson, as well as a rule of thumb you can use to determine how you can pair up other Income Statement metrics like Operating Income and NOPAT with the appropriate Balance Sheet metric when calculating returns-based ratios.

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QUESTION: In the Return on Assets (ROA) calculation, why we do use Net Income? Shouldn’t we use Net Operating Profit After Taxes (NOPAT) instead since Assets represent both equity and debt investors?

Return on Assets = Net Income / Average Assets

It tells you how efficiently a company is using all its assets to generate profits, or how *dependent* a company is on its assets.

It’s useful for comparing similar companies in an industry and seeing which ones are operating most efficiently.

Other, similar metrics include Return on Equity (ROE), defined as Net Income / Average Equity, and Return on Invested Capital (ROIC), defined as NOPAT / Average Invested Capital.

NOPAT = Operating Income * (1 – Tax Rate), and Invested Capital = Common Equity on the Balance Sheet + Debt + Preferred Stock + Other Possible Long-Term Funding Sources.

You use Net Income with Total Assets and Equity because of the definitions of Equity Value and Enterprise Value:

Equity Value: The value of ALL the company’s Assets, but ONLY to equity investors (common shareholders).

Enterprise Value: The value of ONLY the company’s Core Business Assets, but to ALL investors (equity, debt, preferred, and possibly others).

These pairings apply not just to valuation multiples, but also to financial metrics and ratios such as ROA, ROE, and ROIC.

Net Income is only available to common equity investors because debt investors have already “been paid” with the interest they received. You subtract this interest on the Income Statement before arriving at Net Income.

As a result, Net Income pairs with Equity on the Balance Sheet, Equity Value in valuation, and ALL the assets on a company’s Balance Sheet.

It’s the same idea for ROE: you use Net Income because Net Income pairs with Equity on the Balance Sheet.

For ROIC, NOPAT is available to ALL the investors in the company because debt investors have not yet received interest, and Preferred investors haven’t received anything, either.

So you pair it with Invested Capital on the Balance Sheet, Enterprise Value in valuation, and ONLY the core business assets on a company’s Balance Sheet.

So if you wanted to use NOPAT with a company’s Assets, you’d have to subtract out the non-core-business ones and create a new metric, something like “Core Business Assets.”

For example, you might take a company’s Total Assets and subtract out cash, investments, equity investments, and anything else related to side activities (i.e., NOT creating and selling products to customers).

And then you could pair NOPAT with this new metric: NOPAT / Core Business Assets. Maybe you could call it “Return on Core Business Assets,” or ROCBA.

RESOURCES:

https://youtube-breakingintowallstreet-com.s3.amazonaws.com/105-19-Return-on-Assets-Net-Income-Slides.pdf

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