ROA Discussion 1

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ROA Discussion 1발음듣기

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One of the viewers pointed out not incorrectly that one definition of return on asset - so this whole video's going to be on return on asset - that one definition of return on asset, and if you look it up on some of the finance sites or even some finance textbooks, they'll tell you it's net income over total assets.발음듣기

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Which is different from what I told you.발음듣기

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And other sources, namely Wikipedia, will tell you that it is actually - so this is one definition of return on asset.발음듣기

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Another definition is net income. I'll just abbreviate that as NI.발음듣기

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Net income plus interest. So they're adding back your interest. And then they're subtracting out the tax savings due to interest.발음듣기

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And we could a whole video on the tax savings from interest.발음듣기

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And when it makes more sense to raise money with debt versus equity, because of the cost of interest.발음듣기

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But that also increases your chance of bankruptcy, the more debt you take on.발음듣기

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We could do a series of videos on that.발음듣기

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But tax savings from interest. Divided by assets.발음듣기

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This is a definition that Wikipedia gives you.발음듣기

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And then the very first definition I gave you was operating profit over assets.발음듣기

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And then I'll add one more definition to this video, just because I think it's worth talking about.발음듣기

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And I think this is kind of a general theme in finance, is that there's all these formulas for things.발음듣기

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And people memorize them. But in the process, you lose a lot of the intuition.발음듣기

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And it's also important to realize that there are multiple ways of defining the exact same terms.발음듣기

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So people can confidently say the ROA is this.발음듣기

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And you know what? It's never a bad question to ask them what they mean by ROA.발음듣기

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And I think you'll also be surprised by how many people won't be able to tell you what they mean by ROA.발음듣기

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But then the last one, if I have time to go over, we'll call it EBIT.발음듣기

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I know that look like a very strange word.발음듣기

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EBIT divided by assets. But just so you know what EBIT is, EBIT is just Earnings Before Interest and Taxes.발음듣기

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So this is just the same thing as net income plus interest plus taxes.발음듣기

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So it's kind of a pre-tax ROA divided by assets.발음듣기

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So these are all different things.발음듣기

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And you might already say, wait if I took net income - let's actually talk about this for a second.발음듣기

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Let's compare EBIT to operating profit.발음듣기

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You might immediately say, if I took net income - so let's remember EBIT is just an acronym for Earnings Before Interest and Taxes.발음듣기

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So let's see. If our earnings are $350,000. And we were to add back the taxes and the interest.발음듣기

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So we add back the taxes, which gets us to pre-tax.발음듣기

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And we add back the interest, at least in this example, we get to an operating profit number.발음듣기

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So you might say, why is there a different term EBIT instead of, why don't people just always use operating profit?발음듣기

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And the reason why there's a different term is, sometimes you can have the non-operating profit.발음듣기

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So let's say that out of this $10 million of assets - and I didn't go there in the first example because I didn't really want to complicate the issue, but I'll complicate the issue a little bit now.발음듣기

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Let's say out of this $10 million of assets, let's say that $9 million are operating assets.발음듣기

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They're the enterprise. They're the things that are needed to generate the operating profit.발음듣기

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And then you had another $1 million of assets of this $10 million.발음듣기

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That the company really doesn't need to operate.발음듣기

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They just have it around. Maybe they're speculating on oil prices.발음듣기

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Or they're just hedging something. Or they just have a super flush bank account.발음듣기

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So these assets might be generating non-operating income.발음듣기

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So you could have a line here for interest income or investment income.발음듣기

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Let me put that. Investment income.발음듣기

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And then the company might have made some money there.발음듣기

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It might make $10,000 on investment income.발음듣기

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And of course that'll drop to this line.발음듣기

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This'll then become $510,000. The taxes will be $153,000. And the net income is $357,000.발음듣기

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Because we have a 30% tax rate.발음듣기

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And that make sense, right? I added an extra $10,000 of income here.발음듣기

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And then at the end of the day, you're going to tax at 30%, so this should be $7,000 more of earnings.발음듣기

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So that makes sense. $357,000. But this is the difference between operating income and EBIT.발음듣기

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EBIT in this case would be the operating profit plus this investment income.발음듣기

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So EBIT, in the case that I just added some investment income, would be $1,010,000, while operating profit would be $1 million.발음듣기

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I didn't want to go there in the first video, and that's why I just said operating profit divided by assets.발음듣기

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But if you really consider all of the assets, and if you assume that there are some assets there that are non-operating.발음듣기

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They're not really used to make widgets, or to sell widgets or market widgets, or help the CEO in any way do his or her job.발음듣기

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Then whatever this generates is actually non-operating income.발음듣기

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And so EBIT factors that in.발음듣기

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So EBIT, I kind of view that it goes backwards.발음듣기

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It starts with net income. And then it adds back the taxes and interest.발음듣기

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While operating profit, you start at the top line and you go down.발음듣기

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But in general if you take EBIT and you take out the non-operating income, you get back to operating profits.발음듣기

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So that's what EBIT is right here.발음듣기

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And so you can already imagine that both EBIT and the way I defined it initially, operating profit divided by assets.발음듣기

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They're ways of saying, before you consider taxes, what are your assets doing for you?발음듣기

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So once again, if this is a balance sheet, this is the assets, here are your liabilities.발음듣기

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Debt could be one of them.발음듣기

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But in general it could be a bunch of other things.발음듣기

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You might owe other vendors money or whatever.발음듣기

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Then you have your equity. It's important whenever you talk about any of these ratios.발음듣기

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What context? Are you trying to pass the CFA exam, or are you trying to impress your MBA professor?발음듣기

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Or are you trying to get an intuition for helping to become a better investor?발음듣기

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And if you are an investor, you're probably going to want to do the last of the three.발음듣기

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And there, ROA, the Return on Assets is telling you, how good is this company at getting a return out of this thing right here?발음듣기

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I don't care how they paid for it, whether they had debt.발음듣기

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I don't want to think about, are they good at getting low interest?발음듣기

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I don't want to think about, is their CFO good at getting a better interest rate than another CFO?발음듣기

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Or are they better at evading taxes than another company?발음듣기

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All I care is the assets that they have, how good are they at putting those assets to work?발음듣기

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And what type of a return can they get?발음듣기

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So if I calculate it using you EBIT divided by assets, or operating profit divided by assets, if I use either of these as my metric for ROA and Company A has a 10% ROA and Company B has a 15% ROA, then I say, you know what?발음듣기

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I don't care whether B's guy is better at getting a low interest rate.발음듣기

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Or getting some type of tax handout from the government.발음듣기

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Or doing something fancy with where he keeps his subsidiaries.발음듣기

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I just want to know which management is better at getting a return out of these assets.발음듣기

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And these metrics will tell you that.발음듣기

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Because it tells you either how much operating profit is being generated from here, or it could tell you how much EBIT.발음듣기

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In this case, an EBIT might be a little bit more informative.발음듣기

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Because some of income might be generated from non-operating assets.발음듣기

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So maybe the company holds some stock, or it holds some gold or something.발음듣기

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Or it holds some forward contracts to hedge its exposure to oil or foreign currency or something.발음듣기

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So in general if you want to know what I think is the best ROA, I would say it's EBIT over assets, which is very close to operating profit over assets.발음듣기

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And now you say, well Sal, why are these other things here?발음듣기

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And why don't you like them as much?발음듣기

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Well, net income over assets, I think the reason why that definition exists is because: one, net income does factor into these things that frankly I didn't want to think as much about.발음듣기

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But when you talk about return, what you get off the asset, you still are going to pay taxes on them.발음듣기

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And if you do have some financing, you will be paying some interest on that.발음듣기

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So that's why this comes out.발음듣기

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Where they actually just take the bottom line.발음듣기

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When people talk about top line and bottom line, now you know where those words come from.발음듣기

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Top line is revenue. It's the top line of the income statement.발음듣기

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And your bottom line, that's the bottom line of the income statement.발음듣기

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That's where the word comes from.발음듣기

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So that one definition takes this and they divide by the total assets.발음듣기

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But the reason why I don't like that is this definition does not separate out that one company might be better at evading taxes or paying taxes.발음듣기

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And another company might be better at somehow getting better financing from the bank.발음듣기

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And that's not what matters. I care about the assets.발음듣기

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I care just about the left-hand side of the balance sheet.발음듣기

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While this is taking into consideration some of the factors on that side of the balance sheet.발음듣기

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For example, let's say you have two identical companies.발음듣기

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This could be an interesting example.발음듣기

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You have one company - Actually I just realized I'm out of time.발음듣기

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I'll continue the example in the next video, and I'll explain a little bit about the tax savings from carrying debt or interest.발음듣기

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See you in the next video.발음듣기

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