What Is Economic Return on Assets?
Economic Return on Assets represents a refined measure within corporate finance that evaluates how efficiently a company utilizes its total assets to generate profits, taking into account the true cost of all capital employed. Unlike traditional accounting measures, economic return on assets considers both explicit and implicit costs, providing a more holistic view of a firm's true economic performance. This metric is a crucial component of advanced financial analysis, helping stakeholders understand whether a business is creating value beyond its cost of capital. By focusing on the economic profitability derived from a company's asset base, it offers insights into operational efficiency and long-term value creation.
History and Origin
The concept of economic profit, which forms the foundation of Economic Return on Assets, has roots in classical economics, distinguishing between accounting gains and the true economic surplus after considering all costs, including the opportunity cost of capital. While the idea of true economic profit has been discussed by economists for centuries, its application in corporate financial management gained significant traction with the popularization of Economic Value Added (EVA). EVA, a trademarked measure, was introduced and commercialized by the consulting firm Stern Stewart in the early 1990s. Stern Stewart emphasized that traditional accounting profits often fail to capture the true cost of capital and thus may not accurately reflect whether a company is truly creating shareholder value. Joel Stern published articles about the limitations of accounting profits as early as the 1970s, setting the stage for EVA's formal launch.9 The firm aggressively marketed EVA, leading to its widespread adoption as a performance measurement tool for many corporations throughout the 1990s.7, 8 This shift brought concepts like the true economic return on assets to the forefront of corporate financial thinking.
Key Takeaways
- Economic Return on Assets measures a company's efficiency in generating profit from its assets, considering the full cost of capital, including both debt and equity.
- It provides a more accurate picture of value creation than traditional Return on Assets by incorporating the cost of equity.
- A positive Economic Return on Assets indicates that a company is generating returns above the minimum required by its capital providers, thus creating economic value.
- This metric is vital for strategic decision-making, capital allocation, and assessing long-term profitability.
- Its calculation requires adjusting standard accounting figures to reflect a true economic profit.
Formula and Calculation
The Economic Return on Assets (EROA) can be derived from the concept of economic profit. While there isn't one universally standardized formula for EROA, it conceptually measures the economic profit generated per dollar of assets. A common approach involves adapting the definition of Economic Value Added (EVA), which is given by:
To calculate Economic Return on Assets, one would typically divide this economic profit by the invested capital:
Where:
- NOPAT (Net Operating Profit After Taxes): The profit a company would make if it had no debt, calculated as Earnings Before Interest and Taxes (EBIT) multiplied by (1 - Tax Rate). This figure is derived from the income statement.
- Invested Capital: The total amount of money a company has raised from both debt and equity providers to fund its operations and asset base. It represents the total investment made in the company's operating assets.6
- WACC (Weighted Average Cost of Capital): The average rate a company expects to pay to finance its assets, considering the proportion of debt and equity and their respective costs. This represents the company's cost of capital.
This formula effectively measures the spread between a company's return on its operating assets and its cost of funding those assets, expressed relative to the invested capital.
Interpreting the Economic Return on Assets
Interpreting the Economic Return on Assets involves assessing whether a company is generating a return that exceeds its true cost of capital. A positive Economic Return on Assets indicates that the company is creating economic value; its operations are yielding a return higher than what investors and lenders collectively require. This suggests efficient utilization of assets and effective asset management. Conversely, a negative Economic Return on Assets implies that the company is destroying economic value, meaning the returns generated from its assets are not sufficient to cover the overall cost of capital.
Analysts use this metric to evaluate management's effectiveness in deploying capital and to make informed investment decisions. It provides a clearer signal about a company's true performance than traditional financial ratios that rely solely on accounting profit, as it explicitly accounts for the opportunity cost of equity capital.
Hypothetical Example
Consider "AlphaTech Solutions," a hypothetical software development firm.
- NOPAT for the year: $2,500,000
- Total Invested Capital: $20,000,000 (representing the value of its assets, including software, equipment, and cash used in operations)
- Weighted Average Cost of Capital (WACC): 10%
First, calculate the capital charge:
Capital Charge = Invested Capital × WACC
Capital Charge = $20,000,000 × 0.10 = $2,000,000
Next, calculate the Economic Profit (EVA):
Economic Profit = NOPAT - Capital Charge
Economic Profit = $2,500,000 - $2,000,000 = $500,000
Finally, calculate the Economic Return on Assets:
Economic Return on Assets = Economic Profit / Invested Capital
Economic Return on Assets = $500,000 / $20,000,000 = 0.025 or 2.5%
In this scenario, AlphaTech Solutions has an Economic Return on Assets of 2.5%. This positive figure indicates that AlphaTech is generating a return on its assets that exceeds its cost of capital, thereby creating value for its investors. If the return had been negative, it would suggest that the company's operations were not covering the true cost of funding its balance sheet.
Practical Applications
Economic Return on Assets serves several practical applications in the financial world. It is a powerful tool for internal management to gauge the effectiveness of their capital allocation decisions and incentive compensation. Companies aiming to maximize shareholder wealth often use economic profit metrics to align employee actions with value creation. For instance, tying bonuses to a measure that reflects true economic performance can encourage managers to invest in projects that genuinely add value, rather than merely boosting reported net income.
Furthermore, external investors and analysts utilize this metric to evaluate a company's long-term viability and attractiveness. It helps in comparing companies across industries by standardizing the measure of profitability against the capital required to generate it. Academic research also frequently employs similar profitability analysis to understand corporate performance, providing a comprehensive view of how different business activities contribute to returns. U5nderstanding the economic return allows for a deeper assessment of how well a company uses its resources to generate a profit beyond its financing costs.
Limitations and Criticisms
While Economic Return on Assets offers a more insightful view of corporate performance, it is not without limitations. A primary criticism lies in the complexity and subjectivity involved in calculating Economic Profit, particularly in making the necessary accounting adjustments to NOPAT and invested capital. Critics argue that the numerous adjustments required, such as those for goodwill or operating leases, can introduce bias or be inconsistently applied across companies, making comparisons difficult.
4Additionally, like other financial ratios, Economic Return on Assets can be influenced by accounting practices and short-term fluctuations, potentially making it less reliable for assessing long-term trends in isolation. S3ome argue that such metrics may not fully account for intangible assets like brand value or intellectual property, which are crucial drivers of modern businesses but may not be adequately reflected on a balance sheet. Furthermore, the metric might not fully capture the relative risk or size of companies, meaning a higher Economic Return on Assets from a smaller, riskier company might not be directly comparable to a lower return from a large, stable entity.
2## Economic Return on Assets vs. Return on Assets (ROA)
The core distinction between Economic Return on Assets and Return on Assets (ROA) lies in how they account for the cost of capital. Traditional ROA is a common profitability metric that measures how efficiently a company uses its total assets to generate net income. Its formula is simply:
ROA uses accounting profit (net income), which is calculated after deducting interest expense but before considering the cost of equity capital. This means ROA does not fully capture the implicit cost of shareholders' funds. Consequently, two companies with identical operating performances but different capital structure (one heavily debt-financed, the other equity-financed) might show different ROAs, even if their underlying asset efficiency is the same.
1In contrast, Economic Return on Assets goes a step further by incorporating the weighted average cost of capital (WACC) into its calculation, thus reflecting the cost of all capital, both debt and equity. It aims to measure the true economic surplus generated by the assets. While ROA focuses on accounting-based returns, Economic Return on Assets focuses on value creation above and beyond the true economic cost of assets, offering a more comprehensive evaluation of a company's financial health and operational effectiveness.
FAQs
What is the primary difference between accounting profit and economic profit?
Accounting profit is a company's total revenue minus its explicit costs (such as operating expenses, depreciation, and interest payments) as reported on the income statement. Economic profit, however, subtracts both explicit costs and implicit costs, which include the opportunity cost of capital and other resources. This means economic profit provides a more comprehensive measure of a business's true profitability.
Why is Economic Return on Assets considered a better measure than traditional ROA for some analyses?
Economic Return on Assets is often considered superior for certain analyses because it accounts for the full cost of capital, including the implied cost of equity. Traditional Return on Assets only considers explicit costs like interest expense, which can lead to a skewed view of a company's true value creation, especially when comparing companies with different financing structures.
Can Economic Return on Assets be negative? What does that imply?
Yes, Economic Return on Assets can be negative. A negative value implies that the company is not generating enough operating profit from its assets to cover its total cost of capital. This means the company is destroying economic value and its investments are not yielding sufficient returns to compensate its capital providers.
How do accounting adjustments impact the calculation of Economic Return on Assets?
Accounting adjustments are crucial for calculating Economic Return on Assets accurately. These adjustments aim to convert traditional accounting figures, which are often based on historical costs and specific rules, into figures that better reflect the true economic reality and market value of assets and earnings. This includes adjustments for items like research and development expenses, depreciation, or non-operating assets to arrive at a more accurate NOPAT and invested capital figure.
Is Economic Return on Assets primarily used by internal management or external investors?
Economic Return on Assets is valuable for both internal management and external investors. Internal management uses it for strategic planning, resource allocation, and performance measurement to ensure that business units are creating true economic value. External investors and analysts use it as a sophisticated financial analysis tool to evaluate a company's fundamental health, compare its efficiency against competitors, and make informed investment decisions based on actual value creation.