Return on operating assets
/What is the Return on Operating Assets?
The return on operating assets measurement focuses attention on only those assets used to generate revenue. Once measured, a common outcome is that management works to minimize all of the other assets on the books that are not contributing to revenue.
How to Calculate the Return on Operating Assets
The formula for the return on operating assets is to divide net income by the gross recorded amount of all assets used to generate revenue. The calculation is as follows:
Net income ÷ Total carrying amount of all revenue-generating assets = Return on operating assets
Several issues related to this calculation are as follows:
Income calculation. It can make sense to use operating income in the numerator, rather than net income, if the net income figure includes large amounts of interest income or interest expense.
Unusual income exclusions. If there is unusual income not related to the ability of assets to generate revenue, exclude it from the numerator.
Asset exclusions. Do not include in the denominator any assets not associated with revenue-generating activities, such as investment assets.
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Example of the Return on Operating Assets
As an example of how the return on operating assets can be used, Giro Cabinetry has acquired a number of assets through various acquisitions that may no longer be needed. The president tells the controller to develop a return on operating assets measurement, with the intent of spotting equipment that can be disposed of. The controller assembles the following information:
Net income for the past year was $500,000
The gross amount of assets on the books is $4,000,000
There are three excess lathes, recorded at $65,000 in total
There are two excess band saws, recorded at $35,000 in total
There is an extra CNC machine, recorded at $300,000
Based on this information, the company's return on operating assets is:
Net income ÷ Assets used to create revenue
=
$500,000 Net income ÷ ($4,000,000 Gross assets - $400,000 Unproductive assets)
= 13.8% Return on operating assets
Problems with the Return on Operating Assets
While the return on operating assets provides valuable insights, it also comes with several limitations and potential problems, which are as follows:
Excludes non-operating assets. The measurement focuses only on operating assets, excluding non-operating assets like cash, investments, or other assets not directly related to core operations. This exclusion might lead to an incomplete picture of the company's overall performance.
Can be manipulated. Management may manipulate accounting figures (e.g., by reclassifying assets or expenses) to improve the rate of return, making the metric less reliable.
Inconsistent definitions. The definition of "operating assets" can vary between companies, industries, or analysts. This inconsistency can make comparisons difficult.
Ignores capital structure. The measurement does not account for how the company is financed (e.g., debt vs. equity), which may limit its usefulness in assessing overall financial health.
Limited use for asset-intensive businesses. For companies with significant fixed assets, such as manufacturing or utilities, the measurement may not adequately reflect their efficiency due to high depreciation and maintenance costs.
Lacks context. The metric alone doesn’t provide context regarding market conditions, competition, or industry standards, which are crucial for meaningful evaluation.
Focuses on a single point in time. The measurement is often calculated using figures from a single reporting period, which may not reflect long-term trends or seasonality.
Relies on accounting estimates. Operating asset values are based on accounting principles that involve estimates, such as depreciation or amortization. These estimates can vary widely and affect the accuracy of the measurement.
Overemphasis on efficiency. By focusing on asset efficiency, the return on operating assets might encourage short-term decision-making, such as underinvestment in long-term growth opportunities.
Neglects qualitative factors. The return on operating assets does not account for qualitative aspects like brand value, customer loyalty, or employee performance, which can impact a company’s long-term success.
While the return on operating assets is a useful metric for analyzing operational efficiency, it should be used in conjunction with other financial metrics and qualitative assessments to gain a comprehensive understanding of a company's performance.