Adjusted return on assets

What Is Adjusted Return on Assets?

Adjusted Return on Assets (Adjusted ROA) is a financial metric used to evaluate a company's profitability by measuring how efficiently it uses its total assets to generate earnings, after making specific modifications to the reported figures. It falls under the broader umbrella of financial analysis and is a type of profitability ratio that aims to provide a clearer, more normalized view of operational performance. While standard Return on Assets (ROA) uses reported net income directly from the income statement, Adjusted Return on Assets often accounts for non-operating items, extraordinary gains or losses, or other one-time events that may distort a company's underlying earning power. Analysts and investors frequently employ Adjusted Return on Assets to facilitate better comparison between companies and across different reporting periods.

History and Origin

The concept of adjusting financial metrics like Return on Assets stems from the ongoing evolution of financial reporting and the need for more insightful analysis beyond raw reported figures. As businesses grew more complex and accounting standards, while aiming for consistency, sometimes permitted varying treatments for certain items, financial analysts sought ways to normalize performance. The practice of making adjustments to financial statements gained prominence as investors and creditors recognized that reported profits could be significantly influenced by non-recurring events, such as asset sales, large litigation settlements, or restructuring charges. The objective became to isolate the core operating performance, free from distortions caused by these infrequent or extraordinary items. This analytical discipline helps stakeholders assess a company's sustainable earning capacity and compare it more accurately with peers or its own historical performance.

Key Takeaways

• Adjusted Return on Assets modifies reported net income to remove the effects of non-recurring or extraordinary items, providing a clearer view of operational efficiency.
• It helps investors and analysts make more accurate comparisons between companies and assess underlying business performance.
• Adjustments often include one-time gains or losses, restructuring charges, impairment write-downs, or the effects of specific accounting treatments.
• While not a GAAP measure, Adjusted Return on Assets offers a valuable supplemental perspective to traditional profitability ratios.
• The effectiveness of Adjusted Return on Assets depends on the relevance and consistency of the adjustments made.

Formula and Calculation

The formula for Adjusted Return on Assets is a modification of the standard Return on Assets (ROA) formula. It involves adjusting the numerator, net income, to reflect core operational earnings before dividing by total assets.

The general formula is:

Where:

• Net Income: The company's profit as reported on its income statement.
• Adjustments: These are additions or subtractions made to net income to remove the impact of non-recurring, non-operating, or extraordinary items. Common adjustments might include:
  • Adding back one-time losses (e.g., restructuring charges, impairment write-downs).
  • Subtracting one-time gains (e.g., gains on asset sales, litigation settlements).
  • Adjusting for the effects of certain accounting choices (e.g., normalizing depreciation or amortization if they are unusually high or low due to specific events).
  • Normalizing certain operating expenses that are deemed non-recurring.
• Average Total Assets: Typically calculated as (Beginning Total Assets + Ending Total Assets) / 2. This figure is usually derived from the company's balance sheet and represents the average value of all assets the company used to generate its income over the period.

The aim of these adjustments is to present an "adjusted net income" figure that more accurately reflects the ongoing profitability from a company's core operations.

Interpreting the Adjusted Return on Assets

Interpreting the Adjusted Return on Assets involves understanding what the adjusted figure reveals about a company's operational efficiency. A higher Adjusted Return on Assets generally indicates that a company is more effective at generating profit from its asset base, excluding the noise of unusual events. Conversely, a lower Adjusted Return on Assets might suggest inefficiencies in asset utilization or a struggling core business.

When evaluating this metric, it is crucial to consider the nature and rationale behind the adjustments. Analysts look to see if the adjustments truly reflect non-recurring or non-operating events that are unlikely to repeat in the normal course of business. For instance, if a company reports a large one-time gain from selling a non-essential division, removing this gain from net income provides a more accurate picture of how well its remaining core operations generate profit from its existing assets. This adjusted view helps in assessing the company's sustainable earning power and its underlying asset management capabilities, distinct from transient factors. It also aids in comparing companies that might have experienced different one-off events during a given period.

Hypothetical Example

Consider two hypothetical companies, Alpha Corp and Beta Inc., operating in the same industry.

Alpha Corp:

• Net Income: $10 million
• Total Assets (Average): $100 million
• One-time gain from sale of a redundant building: $2 million

Beta Inc.:

• Net Income: $8 million
• Total Assets (Average): $90 million
• One-time restructuring charge: $1 million

Standard Return on Assets (ROA):

• Alpha Corp: $10 million / $100 million = 10%
• Beta Inc.: $8 million / $90 million = 8.89%

Based on standard ROA, Alpha Corp appears more efficient. However, let's calculate the Adjusted Return on Assets for a clearer picture of their core operational efficiency.

Adjustments:

• For Alpha Corp, the $2 million gain from the sale of a building is a non-recurring event and should be subtracted from net income to reflect core operations.
  • Adjusted Net Income (Alpha Corp) = $10 million - $2 million = $8 million
• For Beta Inc., the $1 million restructuring charge is a one-time expense and should be added back to net income.
  • Adjusted Net Income (Beta Inc.) = $8 million + $1 million = $9 million

Adjusted Return on Assets:

• Alpha Corp: $8 million / $100 million = 8%
• Beta Inc.: $9 million / $90 million = 10%

After adjusting for these non-operating items, Beta Inc. shows a higher Adjusted Return on Assets (10%) compared to Alpha Corp (8%). This suggests that Beta Inc.'s core business is more effective at generating profit from its total assets when one-time events are removed, making it potentially a more efficient long-term investment based on this metric.

Practical Applications

Adjusted Return on Assets is a critical tool for various financial stakeholders, offering a more refined view of a company's operational strength.

• Investment Analysis: Equity analysts use Adjusted Return on Assets to normalize financial performance and compare companies within an industry, especially when different firms report various one-time gains or losses. This helps in identifying companies with truly superior underlying operational efficiency. The CFA Institute emphasizes the importance of understanding and adjusting financial reports for more meaningful analysis.
• Credit Analysis: Lenders and credit rating agencies evaluate a company's ability to generate sustainable cash flows to service debt. By removing unusual items, Adjusted Return on Assets provides a clearer indication of a company's consistent earning power, which is vital for assessing creditworthiness. The Federal Reserve Bank of San Francisco highlights how financial ratios aid in understanding a firm's financial health.
• Management Performance Evaluation: Company management might use Adjusted Return on Assets internally to assess the performance of different business units or strategic initiatives, ensuring that evaluations are based on recurring operational results rather than transient events.
• Mergers and Acquisitions (M&A): During due diligence, acquiring companies often adjust the target company's historical financial statements to understand its normalized earning capacity and asset utilization, which directly impacts valuation. A KPMG survey noted that investors value adjustments for one-off items, highlighting their importance in valuation and decision-making.

By focusing on the core business, Adjusted Return on Assets provides a more reliable metric for strategic decision-making and performance benchmarking.

Limitations and Criticisms

While Adjusted Return on Assets offers valuable insights, it is subject to several limitations and criticisms that users must consider.

• Subjectivity of Adjustments: The primary criticism lies in the subjective nature of the adjustments. There is no universal standard for what constitutes a "one-time" or "non-operating" item that should be excluded. What one analyst considers an adjustment, another might view as part of the normal course of business. This subjectivity can lead to inconsistencies and make direct comparisons challenging if different analysts use different adjustment criteria.
• Potential for Manipulation: Because adjustments are not governed by generally accepted accounting principles (GAAP), companies could potentially use them to present a more favorable picture of their profitability by selectively excluding certain expenses or including non-recurring gains. The SEC has issued guidance on the use of non-GAAP financial measures, emphasizing that they should not be misleading and must be reconciled to the most directly comparable GAAP measure.
• Loss of Information: While removing "noise" can be beneficial, over-adjusting can inadvertently strip away important information about a company's actual performance. For example, recurring "one-time" charges might indicate underlying issues in management or business operations, which would be obscured if consistently removed.
• Focus on the Past: Like all historical financial ratios, Adjusted Return on Assets is based on past performance and may not be indicative of future results. It does not account for qualitative factors or future capital expenditures that might impact asset efficiency.
• Does Not Account for Balance Sheet Distortions: While it adjusts the income statement, it does not directly address potential distortions in the balance sheet, such as off-balance sheet financing or fair value accounting for certain assets, which could impact the "Total Assets" figure.

Therefore, users should scrutinize the nature of the adjustments, understand their implications, and use Adjusted Return on Assets as one metric among many in a holistic financial analysis.

Adjusted Return on Assets vs. Return on Assets

The distinction between Adjusted Return on Assets and Return on Assets (ROA) lies in the treatment of the numerator (net income). Standard Return on Assets directly uses the reported net income from a company's income statement, as determined by accounting standards (e.g., GAAP or IFRS). This "unadjusted" ROA provides a straightforward measure of how much profit a company generates for every dollar of assets it owns.

Adjusted Return on Assets, conversely, modifies this reported net income by adding back or subtracting specific items deemed non-recurring, extraordinary, or non-operating. The goal of this adjustment is to "normalize" earnings, presenting a figure that reflects the company's core, ongoing operational profitability, free from the influence of unusual events. While ROA offers a snapshot of reported financial efficiency, Adjusted ROA aims to reveal the underlying, sustainable profitability generated by a company's asset base, making it particularly useful for comparative analysis and long-term valuation when seeking to isolate a business's fundamental earning power.

FAQs

Why is it important to adjust Return on Assets?

Adjusting Return on Assets helps to remove the impact of one-time or unusual events that can distort a company's reported profit. By doing so, it provides a clearer picture of a company's core operational efficiency and its ability to generate earnings from its assets on an ongoing basis. This makes it easier to compare a company's performance over time or against its competitors.

What kind of items are typically adjusted for in Adjusted Return on Assets?

Common adjustments include adding back one-time losses (e.g., restructuring charges, asset impairment write-downs, significant legal settlements paid) or subtracting one-time gains (e.g., gains from the sale of a major asset, extraordinary insurance payouts). The aim is to exclude anything that is not part of the company's regular, recurring business operations.

Is Adjusted Return on Assets a GAAP measure?

No, Adjusted Return on Assets is generally not a GAAP (Generally Accepted Accounting Principles) measure. It is a non-GAAP financial metric, meaning it is not strictly defined or mandated by accounting standards. Companies often report GAAP figures, and analysts or investors then make their own adjustments based on their analytical objectives. Companies that choose to report non-GAAP measures must typically reconcile them back to their closest GAAP equivalent.

How does Adjusted ROA help in investment decisions?

Adjusted ROA helps investors by providing a more reliable basis for comparing investment opportunities. When considering companies for investment, understanding their true operational profitability and asset utilization, stripped of transient factors, is crucial. It supports better valuation models and helps identify businesses with strong, sustainable earning power.

Can adjustments be subjective?

Yes, the adjustments made to calculate Adjusted Return on Assets can be subjective. There isn't a universally agreed-upon list of items to include or exclude, and different analysts may have different interpretations of what constitutes a "non-recurring" or "non-operating" item. This highlights the importance of understanding the specific adjustments made when analyzing a company's Adjusted Return on Assets.