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Financial Literacy

How To Use Return On Assets As A Great Investment Tool

How To Use Return On Assets As A Great Investment Tool

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return on assets

Return on Assets by simple definition is the ratio of a company’s Net Income to its total assets.

Return on Assets = Operating Profit / Total Assets

Operating Profit is the profit attributable to a capital after deducting cost of sales, operating expenses from turnover. It doesn’t take into account expenses such as finance cost/income and  taxes which are more or less influenced by Management decision or government regulation. As such an operational profit of a company is the amount of profit the business can generate for both debt holders, equity holders and government all of whom have a stake in how a company’s earnings can be shared. This way it is easy to compare companies who operate in the same industry but have different capital structure. Some companies are mostly financed by debt, others by equity and the rest a hybrid of debt and equity.  Assets will include Fixed Assets (like Building, Motor Vehicle, Computer Equipment etc), Intangibles (like patent, software acquisitions), Debtors, Cash and Inventory. All of these are used by the company to generate income.

What does it tell me?

Return on Assets is mostly stated in percentage terms and is a powerful tool for gauging how a business is using its assets to generate income. It is also a useful tool for comparing businesses against another and comparing a company’s performance between periods. A return of asset of 10% for example simply means for every N100 a company has put into a business N10 of income was generated. That N10 will now be split between Shareholders, Debt Holders (If the company took loans), and Tax.

[Read Also: Here’s How To Determine Your Net Worth]

How does it affect borrowing cost

From the above it is easy to see how important this tool is at determining whether a company should borrow or not when seeking to finance a project. For example, if a company needs to invest N1m in a project that generates N100k (10%) in operational profit then a return on asset can help determine what the ideal borrowing cost should be. If the company decides to fund the project by total debt at a cost of 10%, then it means it will not have any profit to pay equity holders as all the N100k profit will be used to service the debt.

Conversely if it borrows at less than 10% (say 5%) then it will pay creditors N50k and equity holders 50K meaning shareholders have made N50,000 from a N1m investment without even putting up a single Naira. Investments are surely not this straight forward, but this simple example gives you an idea of how powerful ROA can be. As a rule of thumb, a debt should be borrowed at an interest rate lower than ROA. In fact the higher the debt as a proportion of equity the more important it is for management to target an interest rate that is lower then ROA.

What is driving my ROA?

Return on Asset is a simple ratio and as such how one manipulates the numerator (operating profits) and Denominator (Total Assets) can determine how that ratio turns out. For example, a company can achieve higher ROA when compared to a prior period by simply just reducing Total Assets. It could also do so by agressively increasing turnover whilst cutting cost and without having to increase total assets. This takes us to a the inner components of ROA.

ROA is also a product of (Operational Profit/Revenue) X (Revenue/Total Assets) which in other words is the relationship between profit turnover and asset turnover. Using our earlier example of 10%, a company could achieve that in two ways. The company could have achieved that by having a product of an operational profit turnover of 20% and an asset turnover of 50%. It could as well have achieved that by having an a profit turnover of 50% and asset turnover of 20%. In the former, for every N100 the company invest in the company it generates N50 in revenue, whilst generating operating profit of N20 for every N100 of revenue. In the latter for every N100 the company invests it generates N20 in revenue whilst for every N100 of revenue it generates N50 of operational profit. So basically, one can easily determine if a company’s return on asset is been driven by margin or by assets.

[Read Also: 9 easy steps to negotiate out of a bad loan]

Finally

Return on Asset is an important tool in deciding whether to invest in a project, acquire and asset or even buy a company. If your return on asset is equal to your borrowing cost then your return on equity will always be the same no matter what your debt to equity ratio is. So an investor expecting a return on equity of  20% must ensure that the business can generate a return on asset of  not less than 20%. A return on asset less than a company’s cost of capital is a good sign not to invest. It is also important to compare ROA with companies operating within the same industry to ensure its apples for apples.

Nairametrics is Nigeria's top business news and financial analysis website. We focus on providing resources that help small businesses and retail investors make better investing decisions. Nairametrics is updated daily by a team of professionals. Post updated as "Nairametrics" are published by our Editorial Board.

7 Comments

7 Comments

  1. Ahmed

    March 7, 2015 at 3:08 pm

    GREAT EXPOSITION. FENK YOU

  2. Brian

    July 2, 2019 at 8:34 pm

    ENLIGHTENING!

  3. kennedy

    September 13, 2019 at 8:03 pm

    Great topic.

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Personal Finance

5C’s of creditworthiness: What lenders, Investors look for in a business plan

Business owners need to be aware of the criteria lenders and investors use when evaluating the creditworthiness of entrepreneurs seeking financing.

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Five things to consider before securing a loan

Banks usually are not a new venture’s sole source of capital because a bank’s return is limited by the interest rate it negotiates, but its risk could be the entire amount of the loan if the new business fails. Once a business is operational and has an established financial track record, banks become a regular source of financing.

For this reason, the small business owner needs to be aware of the criteria lenders and investors use when evaluating the creditworthiness of entrepreneurs seeking financing.

Will the business that an entrepreneur actually creates look exactly like the company described in the business plan? Of course, not.

The real value in preparing a business plan is not so much in the finished document itself but in the process it goes through – a process in which the entrepreneur learns how to compete successfully in the marketplace. In addition, a solid plan is essential to raising the capital needed to start a business; lenders and investors demand it.

Lenders and investors refer to these criteria as the five C’s of credit.

READ: 5 ways to raise funding for your business

1. Capital: A small business must have a stable income base before any lender is willing to grant a loan. Otherwise, the lender would not be making, in effect, a capital investment in the business. Most banks refuse to make loans that are capital investment because the potential for return on the investment is limited strictly on the interest on the loan, and the potential loss would probably exceed the reward. In addition, the most common reasons that banks give for rejecting small business loan applications are undercapitalization or too much debt. Banks expect a small company to have an equity base investment by the owner(s) that will help support the venture during times of financial strain, which are common during the start-up and growth phases of a business. Lenders and investors see capital as a risk-sharing strategy with entrepreneurs.

2. Capacity: A synonym for capital is cash flow. Lenders and investors must be convinced of the firm’s ability to meet its regular financial obligation and to repay loans, and that takes cash. More small businesses fail from lack of cash than from lack of profit. It is possible for a company to be showing a profit and still have no cash – that is, to be bankrupt. Lenders expect small businesses to pass the test of liquidity, especially for short term loans. Potential lenders and investors examine closely a small company’s cash flow position to decide whether it has the capacity necessary to survive until it can sustain itself.

READ: How to scale as a small business on a budget

3. Collateral: Collateral includes any asset an entrepreneur pledges to a lender as security for repayment of a loan. If the company defaults on a loan, the lender has the right to sell the collateral and use the proceeds to satisfy the loan. Typically, banks make much unsecured loans (those not backed up by collateral) to business start-ups. Bankers view the entrepreneurs’ willingness to pledge collateral (personal or business assets) as an indication of their dedication to making the venture a success. A sound business plan can improve a banker’s attitude towards venture.

4. Character: Before extending a loan or making an investment in a small business, lenders and investors must be satisfied with an entrepreneur’s character. The evaluation of character frequently is based on intangible factors such as honesty, integrity, competence, polish, determination, intelligence, and ability. Although the qualities judged are abstract, this evaluation plays a critical role in the decision to put money into a business or not.

READ: 7 Ways to pay for your higher education

5. Conditions: The conditions surrounding a funding request also affects an entrepreneur’s chances of receiving financing. Lenders and investors consider factors relating to a business’ operation such as potential growth in the market, competition, location, strength, weakness, opportunities and threats. Another important condition influencing the banks is the shape of the overall economy, including interest rate levels, inflation rate, and demand for money. Although these factors are beyond an entrepreneur’s control, they still are an important component in a banker’s decision.

The higher a smaller business scores on the five C’s, the greater its chances of receiving a loan.

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Written by Chukwuma Aguwa

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Personal Finance

Don’t be fooled by COVID-related scams

Always consult the institution in charge of health-related matters to confirm any fishy information you come across.

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The nature of and the manifestation of the Covid-19 disease is such that there’s only a little time available to remedy the situation before it gets chronic. Although the infection begins by exhibiting mild symptoms, if you do nothing in a short time, it could lead to death in a matter of days.

This whole picture has caused many to become desperate about Covid-related issues, launching into panic mode at the sight of any information. As a result, such people are not far away from falling for fraudsters.

With the different kinds of news flying around, you mustn’t be fooled by Covid-related scams.

The Coronavirus threatens the health of millions of people around the world daily, also killing thousands along the way. To curb the spread and remedy the situation, bodies like the CDC, WHO, and every country’s local health organisation like the NCDC, frequently circulate information around communities. However, it has also led to fraudsters taking advantage to provide fake news, and even asking for donations.

Each day, there seems to be a new account or NGO asking for donations into the health sector, and though some are legit, many are just fraudsters posing to take advantage of innocent citizens. So far, numerous complaints about scams have been recorded, especially with people who are looking to support the health cause in any way they can.

READ: Africa to spend $9 billion on Covid-19 vaccine, access to supply is big problem

Channels used for COVID-related scams 

There are three major ways scammers take advantage of the haziness of the situation to dupe people. To start with, they appeal to the emotions of humans, who see the high death toll and suffering. As a result of what is happening, people have been willing to donate funds for medical supplies, isolation centres, and financial compensation for medical workers.

Scammers take advantage of this by posing as charity organisations and solicit for funds. Most times, as soon as their target is met, they clear their footprint without leaving a trace behind.

Another way they scam people is by manufacturing and selling fake or low-quality health products. Everyone wants to get their hands on a cure, or something that can at least protect them from the virus, and scammers are meeting their needs by providing just that.

READ: China joins WHO vaccine programme as it fills huge gap left by United States

The World Health Organization currently approves only one vaccine, and any other thing outside it is outrightly fake or just a supplement that will help your body. Currently, only the Pfizer vaccine is clinically tested and approved to work. Be sure to not throw your money in the wind by purchasing some of these fake drugs around.

Lastly, scammers create systems to extract a patient’s personal information, thereby having access to the person’s true identity. It could be in the simple form of opening a registration portal where you supply all your details.

Therefore, only give information to approved bodies and not any random online site that appears legit. These fraudulent individuals can do a lot of damage to your identity. Stay vigilant, only communicate with approved bodies, and always ask questions if you are not sure or suspect foul play.

The place of electronics in COVID-related scams

These fraudsters usually reach out to you through the digital sphere. Hence, watch out for cold calls, text messages, or emails requesting donations to certain bodies. The best way to confirm the legitimacy of such a message is to visit the organisation’s official website in a different browser. Never follow the link in the mail or text directly, as it can be easily embedded with spyware. Therefore, a single click could see them extract all your personal information, including bank details.

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Also, please stay away from those who claim to have a cure, and accompany it with testimonies of people who have used it. They are low graders desperate for your money. Vet them by searching online and see what people are saying. In all, always look out for suspicious messages, and opt out if you are sceptical.

In a nutshell, you should not believe any cure, vaccine or supplement that the World Health Organization does not approve of.

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Conclusion

The government or legit health institutions do not cold call citizens to request donations or coerce them into making one. If you receive a call out of the blues, chances are it’s a scam, which is why they mostly try to hurry you to donate before you realise it. Always consult the institution in charge of health-related matters to confirm any fishy information you come across.

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