Return On Assets

Return on assets is the amount a business earns on all its resources not only shareholder equity and long-term borrowing but short-term resources generated by effective management of working capital. A business may seek short-term, low-rate loans or buy goods on credit that it resells for cash, thus increasing the assets available for deployment at low or no cost. Those assets contribute to incremental increases in earnings, boosting both return on equity and
return on assets.

Suppose a business maintains an average amount of short-term assets of $20 million over a year (by continually repaying the obligations as they come due and incurring new ones as rollovers). That couldincrease incremental annual earnings by, say, $2 million. Thus, a company with shareholder equity of $100 million and long-term debt of $50 million, carrying that additional $20 million in the short term andearning $17 million, generates a return on assets of 10%. This deployment boosts return on investment to 11.3% (17/150) andreturn on equity to 17% (17/100).

Return on assets is thus the toughest measure of performance basedon returns, as it reveals the results of deploying all the assets at management’s disposal. Starting with a high return on assets shouldyielda high return on investment and hence on equity. (Some analysts calculate a “financial leverage index” equal to the return on equity divided by the return on assets.)

Higher returns on assets are achievedby squeezing earnings out of fewer or smaller asset bases. Microsoft starts off with a return on assets of 25%, suggesting a relatively low level of asset intensity, freeing it from dependency on debt and enabling it to generate returns on equity of nearly 10 points more. At the other extreme, GE starts off with a return on assets of just 3%, meaning it must manage its capital structure to use debt skillfully and deploy assets efficiently in order to get the higher returns on equity of about 27% that it achieves.

Microsoft is asset-nonintensive, whereas GE is quite assetintensive. The earnings of many companies are driven by brand names and/or inventory and distribution systems far more than by the plants andother physical resources that make up their balance sheet assets. Microsoft relies more on fixedand other assets but also is able to extract prodigious earnings from its brandname andmarket position. GE’s asset-intensive business requires heavy investment in plants andequipment even as its products enjoy enormous brandrecognition.

It is too soon to tell how Amazon.com will fare in the contest for high returns on assets. Certainly its business model is designed to minimize asset intensity. Its brandname and Internet presence are the key drivers of sales and hence earnings. It minimizes its fixed asset needs by avoiding the bricks-and-mortar store operations to which Barnes & Noble and other traditional retailers devote resources. Amazon.com’s just-in-time inventory management is designed to reduce the carrying costs of inventory. Its trade terms with customers andsuppliers drive incremental earnings by superior short-term working capital management it receives revenues from customers as products are ordered but usually need not pay its suppliers for those goods until some 30 to 60 days later.