To truly understand return on assets, you must first be able to differentiate between operating and non-operating assets.
Operating assets are economic resources owned by the owners of the business. Operating assets are bought to generate future revenue and can usually be converted to cash in the future. This means they can potentially be resold after use. Operating assets often include:
- Cash – at a minimum your must have cash to cover your break-even expenses
- Equipment/ machinery/ vehicle for smooth running of your operations or improve productivity
- Buildings – you can choose to own or rent your office space. If you choose to own your building that will also be classified as an asset
Non-operating assets are assets that are not required to continue operations. For example, a business might own some real estate that is not used in operations. The business might have invested in it for operations but later chose to move the business. Alternatively, a business might choose to invest in real estate to generate non-operating income.
Another example will be a vehicle initially purchased for business purposes but has since been converted into a vehicle for personal travel.
Computing return on assets
The efficiency of the assets you accumulate is measured by the return on your asset. Return on asset is measured by net income divided by total operating assets. So, if you made 10,000 last year and your total operating assets were 5,000, your return on operating assets will be 10,000/5,000 = 200%. This means that you were able to double the amount you started out with. Your assets are being put into good use.
Before computing your return on assets, it is important to make an adjustment for non-operating assets. Including this in your calculation can distort your results.
Assessing effective use of your assets
Not only is it important to watch profits also it is important to manage your assets. Keeping assets idle, lowers the return you can get on your investment. You should know how much assets you need to run your business and maintain growth. Excessive assets should be re-directed to other investments so non-operating income can be generated for the business.
Assets in your business should be producing more than you can make from saving your income in a CD or savings account. If you can invest the same amount of resources somewhere else and get a higher return, then running your business is not your most profitable choice.
Let us assume you had $10,000 and you had a choice to start your own business or invest in an alternate opportunity. If you estimated you can double your investment in running a business then investing in a business is more desirable. On the other hand, if you can earn more somewhere else then running a business will not be the smart way to go.
|Initial investment||$ 10,000||$ 10,000|
|Income||$ 20,000||$ 5,000|
|Rate of return||
You want to establish a minimum return for each asset you invest in. If not, you could easily find profits decrease as income increases. This is because expenses like depreciation and interest expense normally associated with assets will increase while revenue stays the same or decline. Managing the return on your assets is just as important as managing profits. Operating assets must possess the ability to increase revenue or decrease expenses: The owner should either spend less overtime by owning the asset or the asset should increase productivity allowing the business to take on more customers.