Return on Assets (ROA)
The right branch of Exhibit 4.1 relates to analyses of profitability using rate of return measures, which presume that a certain amount of investment generates economic profits. A simple example is interest earned on a savings account. A straightforward computation of the rate of return on such an investment is the interest income earned divided by the amount deposited. Conceptually, the analysis of returns to creditors and equity shareholders is similar. In the analysis of financial statements, the two most common measures of rate of return are ROA and ROCE, or sometimes just ROE (return on equity). Our discussion of rate of return analysis begins with ROA. The next section transitions to an examination of ROCE.
The right branch of Exhibit 4.1 relates to analyses of profitability using rate of return measures, which presume that a certain amount of investment generates economic profits. A simple example is interest earned on a savings account. A straightforward computation of the rate of return on such an investment is the interest income earned divided by the amount deposited. Conceptually, the analysis of returns to creditors and equity shareholders is similar. In the analysis of financial statements, the two most common measures of rate of return are ROA and ROCE, or sometimes just ROE (return on equity). Our discussion of rate of return analysis begins with ROA. The next section transitions to an examination of ROCE.
The rate of ROA measures a firm’s success in using assets to generate earnings independent of the financing of those assets. Thus, a properly calculated ROA will be unaffected by the proportion of debt versus equity financing and the costs of those types of capital. ROA is calculated as:
The numerator of ROA adjusts net income to exclude the effects of any financing costs. Thus, the measure of profits pertinent to ROA is net income before financing costs.Because accountants subtract interest expense when computing net income, you must add it back when computing ROA. However, firms deduct interest expense in measuring taxable income. Therefore, the incremental effect of interest expense on net income equals interest expense times one minus the marginal tax rate. That is, you add back the full amount of interest expense to net income and then eliminate the tax savings from that interest expense.
The tax savings from interest expense depends on the statutory tax rate in the tax jurisdiction where the firm raises its debt, and these vary substantially. For example, as of the date this text was written, the statutory federal tax rate is 35% in the United States, 28% in Norway, 23% in the United Kingdom, 15% in Canada, and 0% in the Cayman Islands. In the United States, firms must disclose in a note to the financial statements why the average income tax rate (defined as income tax expense divided by net income before income taxes) differs from the federal statutory tax rate of 35%. The statutory federal rate will differ from a firm’s average tax rate because of
The tax savings from interest expense depends on the statutory tax rate in the tax jurisdiction where the firm raises its debt, and these vary substantially. For example, as of the date this text was written, the statutory federal tax rate is 35% in the United States, 28% in Norway, 23% in the United Kingdom, 15% in Canada, and 0% in the Cayman Islands. In the United States, firms must disclose in a note to the financial statements why the average income tax rate (defined as income tax expense divided by net income before income taxes) differs from the federal statutory tax rate of 35%. The statutory federal rate will differ from a firm’s average tax rate because of
1. state, local, and foreign tax rates that differ from 35%
2. revenues and expenses that firms include in accounting income but that do not impact taxable income
You can approximate the combined statutory federal, state, local, and foreign tax rate applicable to tax savings from interest expense using 35% plus or minus the amounts disclosed related to Item 1 above. Permanent differences in Item 2 usually do not relate to interest expense and therefore should not affect the statutory tax rate applicable to interest expense deductions. To simplify the calculations, we will follow the common practice of using the statutory federal tax rate of 35% in the computations of the tax savings from interest in the numerator of ROA throughout this book. Because accountants do not subtract dividends on preferred and common stocks in measuring net income, calculating the numerator of ROA requires no adjustment for dividends.
The rationale for adding back the noncontrolling interest in earnings relates to attaining consistency in the numerator and the denominator of ROA. The denominator of ROA includes all assets of the consolidated entity, not just the parent company’s share. Net income in the numerator, however, represents the parent’s earnings plus the parent’s share of the earnings of consolidated subsidiaries. Consistency with the inclusion of all of the assets of the consolidated entity in the denominator of ROA requires that the numerator include all of the earnings of the consolidated entity, not just the parent’s share. The addback of the noncontrolling interest in earnings accomplishes this objective
2. revenues and expenses that firms include in accounting income but that do not impact taxable income
You can approximate the combined statutory federal, state, local, and foreign tax rate applicable to tax savings from interest expense using 35% plus or minus the amounts disclosed related to Item 1 above. Permanent differences in Item 2 usually do not relate to interest expense and therefore should not affect the statutory tax rate applicable to interest expense deductions. To simplify the calculations, we will follow the common practice of using the statutory federal tax rate of 35% in the computations of the tax savings from interest in the numerator of ROA throughout this book. Because accountants do not subtract dividends on preferred and common stocks in measuring net income, calculating the numerator of ROA requires no adjustment for dividends.
The rationale for adding back the noncontrolling interest in earnings relates to attaining consistency in the numerator and the denominator of ROA. The denominator of ROA includes all assets of the consolidated entity, not just the parent company’s share. Net income in the numerator, however, represents the parent’s earnings plus the parent’s share of the earnings of consolidated subsidiaries. Consistency with the inclusion of all of the assets of the consolidated entity in the denominator of ROA requires that the numerator include all of the earnings of the consolidated entity, not just the parent’s share. The addback of the noncontrolling interest in earnings accomplishes this objective
Most publicly traded corporations do not disclose the noncontrolling interest in earnings because its amount, if any, is usually immaterial. Thus, you typically make this adjustment only for significant noncontrolling interests. PepsiCo reports a small but growing amount of noncontrolling interest, so we will make this adjustment in the PepsiCo computations that follow. Calculating the numerator of ROA is accomplished most easily by starting with net income. Because net income before financing costs in the numerator of ROA reports the results for a period of time, a typical denominator uses a measure of average assets in use during that same period. This computation aligns the income measure in the numerator with the average assets in place during the period. Using average total assets is not mandatory, however, in the sense that using beginning total assets is not necessarily wrong. (In fact, if total assets have not changed significantly during the period, there will be little difference between the beginning amount and the average.) The use of average total assets is a simple way to account for the changing level of investments in total assets upon which profits are judged. Thus, for a nonseasonal business, an average of assets at the beginning and end of the year is usually satisfactory. For a seasonal business, you might use an average of assets at the end of each quarter.
Refer to the financial statements for PepsiCo in Appendix A. Also refer to the ROA and other ratio computations in the Analysis Spreadsheet of the FSAP presented in Appendix C. The calculation of ROA for 2012 is as follows:
Refer to the financial statements for PepsiCo in Appendix A. Also refer to the ROA and other ratio computations in the Analysis Spreadsheet of the FSAP presented in Appendix C. The calculation of ROA for 2012 is as follows:
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