ROA discussion 1

one of the viewers pointed out not incorrectly that one definition of return on asset so this whole video is going to be on return on asset that one definition of return on asset and I if you look it up on some of the finance Isis Finance sites or even some finance textbooks they'll tell you is net income net income over total assets which is different from what I told you and other sources and 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 n dot I net income plus interest so they're adding back your interest and then they're subtracting out the tax savings due to interest minus tax savings due to interest tax savings from interest and we could do 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 well do we could do a series of videos on that but tax savings from interest divided by assets this is the definition that Wikipedia gives you and then I gave you my very first definition I gave you was operating profit operating profit over assets and then I'll add one more definition to this video just because I think it's worth talking about it I think this is kind of a general theme in finance is that there's all these formulas for things and people you know memorize them and 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 term so people can confidently say oh they're ROI 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'd also be surprised by how many people won't be able to tell you what they mean by ROA but the last one if I have time to go over we'll call it e bit I know that looks like a very strange word EBIT divided by assets but just so you know what EEB it is EEB it is just earnings before interest in taxes so this is just the same thing as income net income plus interest plus taxes so it's kind of a pre-tax 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 a bit to operating profit you might immediately say if I took net income so a bit let's remember a bit it's just an acronym for earnings before interest in taxes so let's see if our earnings are $350,000 and we were to add back the taxes in the interest we add back the taxes gets us to pre-tax and we add back to the interest we get to at least in this example we get to an operating profit number so you might say why is there a different term EEB it instead of one of the people just always use operating profit and the reason why there's a different term is sometimes you can have non operating profit so let's say that out of this 10 million dollars of assets that 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 nine let's say out of this 10 million dollar of assets let's say that nine million dollars let's say that nine million dollars are kind of operating assets there the enterprise they're the things that are needed to generate the operating profit and then you had another 1 million dollars of assets that of this 10 million that is just you know the company really doesn't need it to operate they just have it around maybe they're speculating on oil prices or they're just hedging something or they're they just have a super flush bank account so these assets might be generating non operating income so you could say you could you could have a line here for interest income or investment income we put that investment income and then the company might have made some money there might have made eight I don't know might make $10,000 on investment income and of course that'll drop to this line this will then become five hundred ten thousand the taxes will be one hundred fifty three thousand and the net income is what like one three hundred and fifty six thousand or something along those and actually three hundred fifty seven thousand because you have a 30 percent tax rate now that makes sense right I added an extra ten thousand dollars of income here and at the end of the day you're going to tax at a thirty percent so it should be seven thousand dollars more of earnings so that makes sense three fifty seven thousand dollars but this is the difference between operating income and EBIT EBIT in this case would be the operating profit plus this investment income so II bit in the case that I just added some investment income would be you know 1 1 million 1 million ten thousand dollars while operating profit would be 1 million dollars 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 but they're just they're not really used to make widgets or to sell widgets or marketing widgets or or help the CEO in any way kind of be do his job or her job then you look whatever this generates is actually non operating income and so II bit factors that in so even I kind of view it 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 a bit and you take out the non operating income you get back to operating profits so that's what II bid is right here and so you can already imagine that both a bit 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 you know in general these are your it could be a bunch of other things you might owe other vendors money or whatever then you have your equity it's important when you ever talk about any of these ratios you know context are you trying to pass the CFA exam or you're trying to impress your MBA professor or you're trying to get an intuition for helping you becoming a better investor and I like to well you know if you are investor you're probably going to want to do the last of the three and there are a is telling you the return on assets 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 I don't want to think about are they good at getting low interest I don't 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 EBIT divided by assets or operating divided profit divided by assets if i use this is DS is my metric for our away and i have what 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 with you know 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 right because it tells you either how much operating profit is being generated from here or it could tell you how much II bit and would in case an D bit might be a little bit more informative because there might be some of this income might be generated from non operating assets so you know some some maybe the company holds some stock or it or it holds some gold or something or it holds some forward contracts to hedges exposure to oil or foreign currency or something so in general if you want to know what what I think is the best ROA I would say it's a bit over assets which is very close to operating profit over assets and now you say well Sal why are these other things here and and why don't you like them as much well net income over assets I think the reason why that definition because one net income it factors it does factor in these things that frankly I didn't want to think as much about but in terms of you know when you talk about return your 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 they take the you know when people talk about top but 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 divided by the total assets but the reason why I don't like that the reason why I don't like that is B it doesn't separate out 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 you could have company a let's say you have two identical companies this could be an interesting example you have one company whoops 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 interest tax saving from interest as well or sorry the tax savings from from from from carrying debt or from interest see in the next video