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. Which is different from
what I told you. And other sources, namely
Wikipedia, will tell you that it is actually-- so this
is one definition of return on asset. Another definition
is net income. I'll just abbreviate
that as NI. Net income plus interest. So
they're adding back your interest. And then they're
subtracting out the tax savings due to interest. And we could a whole video on
the tax savings from interest. And when it makes more sense
to raise money with debt versus equity, because of the
cost of interest. But that also increases your chance
of bankruptcy, the more debt you take on. We could do a series
of videos on that. But tax savings from interest.
Divided by assets. This is a definition that
Wikipedia gives you. And then the very first
definition I gave you was operating profit over assets. And then I'll add one more
definition to this video, just because I think it's worth
talking about. And I think this is kind of a
general theme in finance, is that there's all these
formulas for things. And people memorize them. But in the process, you lose
a lot of the intuition. And it's also important to
realize that there are multiple ways of defining the
exact same terms. So people can confidently say
the ROA is this. And you know what? It's never a bad question
to ask them what they mean by ROA. And I think you'll also be
surprised by how many people won't be able to tell you
what they mean by ROA. But then the last one, if I have
time to go over, we'll call it EBIT. I know that look like
a very strange word. EBIT divided by assets. But just so you know what EBIT
is, EBIT is just Earnings Before Interest and Taxes. So this is just the same thing
as net income plus interest plus taxes. So it's kind of a pre-tax
ROA divided by assets. So these are all different
things. And you might already say, wait
if I took net income-- let's actually talk about
this for a second. Let's compare EBIT to
operating profit. You might immediately say, if
I took net income-- so let's remember EBIT is just an acronym
for Earnings Before Interest and Taxes. So let's see. If our earnings are $350,000. And we were to add back the
taxes and the interest. So we add back the taxes, which
gets us to pre-tax. And we add back the interest,
at least in this example, we get to an operating
profit number. So you might say, why is there
a different term EBIT instead of, why don't people just always
use operating profit? And the reason why there's a
different term is, sometimes you can have the non-operating
profit. 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. Let's say out of this $10
million of assets, let's say that $9 million are
operating assets. They're the enterprise. They're the things that are
needed to generate the operating profit. And then you had another
$1 million of assets of this $10 million. That the company really doesn't
need to operate. They just have it around. Maybe they're speculating
on oil prices. Or they're just hedging
something. Or they just have a super
flush bank account. So these assets might
be generating non-operating income. So you could have a line here
for interest income or investment income. Let me put that. Investment income. And then the company might have
made some money there. It might make $10,000 on
investment income. And of course that'll
drop to this line. This'll then become $510,000. The taxes will be $153,000. And the net income
is $357,000. Because we have a
30% tax rate. And that make sense, right? I added an extra $10,000
of income here. And then at the end of the day,
you're going to tax at 30%, so this should be $7,000
more of earnings. So that makes sense. $357,000. But this is the difference
between operating income and EBIT. EBIT in this case would be the
operating profit plus this investment income. So EBIT, in the case that I
just added some investment income, would be $1,010,000,
while operating profit would be $1 million. I didn't want to go there in
the first video, and that's why I just said operating profit
divided by assets. But if you really consider all
of the assets, and if you assume that there are some
assets there that are non-operating. 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. Then whatever this generates
is actually non-operating income. And so EBIT factors that in. So EBIT, I kind of view that
it goes backwards. It starts with net income. And then it adds back the taxes
and interest. While operating profit, you start at
the top line and you go down. But in general if you take
EBIT and you take out the non-operating income, you get
back to operating profits. So that's what EBIT
is right here. And so you can already imagine
that both EBIT and the way I defined it initially, operating profit divided by assets. They're ways of saying, before
you consider taxes, what are your assets doing for you? So once again, if this is a
balance sheet, this is the assets, here are your
liabilities. Debt could be one of them. But in general it could be
a bunch of other things. You might owe other vendors
money or whatever. Then you have your equity. It's important whenever
you talk about any of these ratios. What context? Are you trying to pass the CFA
exam, or are you trying to impress your MBA professor? Or are you trying to get an
intuition for helping to become a better investor? And if you are an investor,
you're probably going to want to do the last of the three. 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? I don't care how they paid for
it, whether they had debt. I don't want to think
about, are they good at getting low interest? I don't want to think about, is
their CFO good at getting a better interest rate
than another CFO? Or are they better at evading
taxes than another company? All I care is the assets that
they have, how good are they at putting those
assets to work? And what type of a return
can they get? 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? I don't care whether B's guy
is better at getting a low interest rate. Or getting some type of tax
handout from the government. Or doing something fancy
with where he keeps his subsidiaries. I just want to know which
management is better at getting a return out
of these assets. And these metrics will
tell you that. Because it tells you either how
much operating profit is being generated from here,
or it could tell you how much EBIT. In this case, an EBIT might be a
little bit more informative. Because some of income might
be generated from non-operating assets. So maybe the company holds some
stock, or it holds some gold or something. Or it holds some forward
contracts to hedge its exposure to oil or foreign
currency or something. 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. And now you say, well Sal, why
are these other things here? And why don't you like
them as much? 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. But when you talk about return,
what you get off the asset, you still are going
to pay taxes on them. And if you do have some
financing, you will be paying some interest on that. So that's why this comes out. Where they actually just
take the bottom line. When people talk about top line
and bottom line, now you know where those words
come from. Top line is revenue. It's the top line of the
income statement. And your bottom line, that's
the bottom line of the income statement. That's where the word
comes from. So that one definition takes
this and they divide by the total assets. 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. And another company might be
better at somehow getting better financing
from the bank. And that's not what matters. I care about the assets. I care just about the
left-hand side of the balance sheet. While this is taking into
consideration some of the factors on that side of
the balance sheet. For example, let's say you have
two identical companies. This could be an interesting
example. You have one company-- Actually
I just realized I'm out of time. 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. See you
in the next video.