Businesses succeed by making money, and in general, the greater the return a company can get from the assets it has, the more successful it will be. Most businesses end up having to take on debt in order to get the financing they need, and that can make their returns on equity much different from their returns on assets. For unlevered companies, however, calculating the return on assets is much simpler.
Looking at return on assets
The basic formula for the return on assets is simple. Take the net income of a company and divide it by its total assets. The resulting percentage is the return that the company generates from the assets on its balance sheet.
For companies that have debt, some investors prefer to take into account the money that the company spends on interest expense. The net income figure deducts interest expense, so adding it back in can give you a better sense of the return on assets that takes advantage of the leverage from borrowed money.
However, for an unlevered business, there will not be any interest expense, because the company won't have any debt to finance. Moreover, because debt is typically the biggest liability on a company's balance sheet, a company that lacks debt will have few, if any, liabilities. As a result, its return on assets will be similar to its return on equity, because the difference between total assets and shareholders' equity will be minimal.
Using unlevered-company return on assets
It can be interesting to look at returns on assets for an unlevered company that is considering taking on debt for the first time. The usual justification for debt financing is that a company believes it can earn a better return on money than the cost of capital, and thus taking on debt should increase the company's overall return on equity.
Note, however, that even a profitable venture financed by debt can still reduce returns on assets. That will occur if the marginal return on the debt-financed venture is less than the return on the unexpanded business. That's one reason why investors are sometimes skeptical of proposed expansion plans if they are expected to generate a smaller rate of return than the business has historically produced -- even if that return can add to profits.
An unlevered company is the simplest to analyze, and knowing its return on assets not only tells you about its profitability but also gives you a baseline for measuring future success. Take the time to look at returns on assets for the companies you invest in, and you'll know a lot more about how they make money for you.
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