Definition
Return on net assets helps to understand how the business uses its assets base to generate the return. A higher return on net assets is desirable than a lower return on net assets because higher business efficiency is associated with a higher return on assets. In general terms, the return on net assets helps measure the business’s financial performance in terms of profitability and efficiency.
Explanation of return on net assets
Return on net asset provides connecting aspects between the business profitability and efficiency. If the business has a higher return on assets, it has used the asset efficiently. On the other hand, if the business has a lower return on assets, it means it has not efficiently used assets.
Further, such a ratio is more relevant in the case of the capital incentive companies due to a higher asset basis. Similarly, the sector-wise importance of such ratios cannot be ignored. For instance, return on net assets is more relevant in the case of manufacturing concerns than service.
How to calculate return on net assets
The formula to calculate return on net assets is following,
RONA = Net business profit / (Net working capital + fixed assets)
Networking capital = current asset – current liability.
The numerator of the formula contains net profit, and the net profit is calculated by deducting all the business expenses from business revenue. So, the net profit can be enhanced by taking steps to increase revenue and control expenses.
RONA is more concerned about using the assets and enhancing the revenue base. Further, the denominator contains the value of the fixed assets and net working capital. Hence, RONA is about using fixed assets and working capital to generate a return on assets.
Steps to calculate return on net assets
Following are the steps for calculating the return on net assets.
1-Determine the net profit
The net profit can be obtained by reviewing the income statement of the business. The net profit is given at the bottom of the income statement. Further, net profit is reached after deducting all the expenses like admin, tax, and finance etc.
2-Determine fixed assets and net working capital
The business’s fixed assets can be obtained by reviewing the balance sheet, and these assets are presented in the non-current assets section. Further, the net book value of the assets is used as it’s a reflection of the current asset position. Similarly, net-working capital can be obtained by deducting current liability from current assets.
3-Divide net profit by fixed assets and net working capital
The net profit obtained in step-1 is divided by values obtained in step-2. It leads to the calculation of the RONA.
Example of calculating and interpretation of return on net assets
Suppose ABC limited has fixed assets amounting to $20,000 and networking capital amounting to $10,000. The net profit generated by the company amounts to $$2,000. So, these figures can be put in the formula to calculate the return on net assets.
RONA = Net business profit / (Net working capital + fixed assets)
RONA = $2,000/ ($10,000+ $20,000)
RONA = $2,000/ $30,000
RONA = 6.7%
It means the business has generated 6.7% in profit for the total assets implied in the business. The profit used in the calculation is after deducting all the expenses. So, to increase the return on net assets, the business managers can control the expenses or increase revenue.
Benefits of return on net assets
Following are some of the benefits of return on net assets.
- It helps to assess business profitability in terms of efficiency.
- Different companies in the same sector can be compared by calculating the return on net assets.
- It gives an idea to the business management if they have been using assets at their full potential.
- The performance of different production plants can be compared with the RONA. Further, it enables the business management to take corrective action to improve the plant’s performance.
- Improvement of RONA can be considered as a long-term business goal. However, this matric needs to be analyzed in terms of business strategy point of view. For instance, the impact of a major restructuring and other plant closures and litigations need to be considered.
- RONA helps to formulate the capital investment plan in terms of profit priority. For instance, the business should consider expanding the plants with higher profitability.
Problems with the return on net assets
Following are some of the issues with the return on net assets.
- Sometimes, there may be some unusual income/expenses distorting profit and RONA.
- The intangible assets acquired during the acquisition need to be eliminated.
- There may be problems with the written-down value of the fixed assets. For instance, different companies have different depreciation policies. Hence, a comparison of the RONA for different companies may not be logical.
- RONA does not assess ability of the business to create future value. Further, it does not explain a reason for the control of expense or reduced revenue.
RONA as a key performance indicator
RONA can be used as a key performance indicator to assess manager performance. For instance, the current RONA of the business is 2%, and the industry average is 5%. It means there is potential for the business to enhance assets utilization and lead to higher profitability. Similarly, the managers’ remuneration can be linked with the improvement of RONA, and it leads to the alignment of the manager’s and business’ interests.
Conclusion
Return on net assets is an important financial metric, and it explains business profitability in connection with the assets implied by the business. A higher return on net assets is more desirable as it indicates the business’s ability to control expenses and increase revenue using assets. On the other hand, a lower value of the return on net assets is associated with the inability of the business to utilize assets for return generation.
Further, RONA can be compared for different companies and plants to assess a need to take corrective action. Likewise, improvement in the RONA can be set as a long-term goal to improve performance and achieve strategic success.
However, there are some potential problems with this metric as sometimes there can be problems with calculating profit. For instance, some unusual transactions can impact the current profitability and lead to distortion of the RONA.
Frequently asked questions
How Just in time – JIT is connected with RONA?
The JIT is connected with the RONA as JIT believes in maintaining lower/no inventory value, leading to lower net assets. Hence, the implementation of JIT is expected to improve the RONA.
How can management distort the RONA?
The management can distort the RONA by using assets throughout the year and selling these assets when preparing financial statements. So, an element of the profit is incorporated in the calculation and the asset is eliminated. Hence, resulting in an inflated return on net assets.
Why is higher RONA desirable?
Higher RONA is desirable as it leads to higher profitability and higher operational efficiency. On the other hand, lower RONA indicates lower business profitability and lower operational efficiency.
Is it logical to compare RONA between different companies?
It’s not logical to compare the RONA between different companies as some businesses may have an expensive asset base than others. For instance, if the business has an expensive asset base, it will lead to lower RONA and vice versa.
Provide an example of the asset incentive industry and why it’s expected to have a lower RONA?
The airline industry is one of the examples of the asset incentive industry. Since the value of the airliners is expected to be higher. So, it leads to higher fixed assets and lowers RONA.
What’s the benchmark of RONA?
Generally, 5% RONA is considered to be good for asset incentive business. Similarly, 20% RONA is considered to be good for businesses with a lower asset base.
