Ratios: Profit Margin x Asset Turnover = Return On Assets

14. Financial Statement Analysis

Ratios: Profit Margin x Asset Turnover = Return On Assets - Video Tutorials & Practice Problems

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Ratios: Profit Margin x Asset Turnover = Return On Assets

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Alright. So we've learned about the return on assets before now, we're gonna decompose that ratio a little bit and get better information. Let's check it out. Alright. The return on assets. Remember our away it measures the income a company gets company earns based on the amount of assets it maintains. So we'll review that ratio in a second. Just remember that our away. Well it was a common. Well we learned about two things with it. We learned about profitability and we learn about efficiency with this ratio and we'll see why once we decompose it a little better so we can break up the R. O. A. Using two other ratios. You might have learned about these already. If not you're gonna learn about them here. Cool. So this gives us a little more information of how we derive our our away and how we decompose it. So let's check it out. Remember that are away? We learned it as net income over average total assets. So when we first discussed our way, that's how we learned it. Net income divided by average total assets. Well we're gonna break it up into two ratios. Now the R. O. A. Is going to be equal to the profit margin, times the total asset turnover. Alright. So those are two other ratios that we learn about. And when we multiply them together, it gives us a return on assets. So our profit margin is this first ratio net income divided by net sales? That's tells us so look below the profit margin. It tells us how much net income we get for each dollar of sales, right? How much of the numerator per one of the denominator? So how much net income per dollar of sales. So remember sales. That's our top of the income statement and net income, that's the bottom of the income statement. So we when we sell something to a customer we'll we gotta pay for it cost a good sold operating expenses, interest, all the things we pay for. And then we finally get to net income. Right? So the profit margin tells us how much at the end of the day we keep for each dollar we sell and then the second one total asset turnover. Well that tells us for each dollar of assets, right? For each dollar of the denominator, how much of the numerator we get. So we gotta we gotta maintain a level of assets for business to function properly. And how do we turn those assets into sales? Right. So the total asset turnover turnover tells us how many dollars of sales we earn per dollar of total assets owned. Okay, So what does this tell us? Right, well, before we get into the last thing here, notice why this equals each other, right? Net income over average total assets. That's the R. O. A. Well look, when we do this multiplication, we've got net income divided by net sales and the net sales is in the numerator, net sales in the denominator? We'll remember from algebra when something is in the numerator and the denominator, they cancel out. So what's left net income in the numerator, average total assets in the denominator. So that's why this equals our return on assets. So why don't we just calculate our return on assets straight up? Why do we need to go through these extra steps? We'll notice what it does tell us. It tells us how we can increase our our away. Now we have two ways to increase our our away. First we can increase our profit margin right? By increasing our profit margin. R. R. O. Is going to go up because this first multiplication is going to be a bigger number or we can increase our total asset turnover, right? Because the second number is going to be a bigger number. So our multiplication will be a bigger number. So that's pretty good information. Now when we want to increase our R. O. A. We have two things we can focus on. First increase our profit margin, our profitability or we can increase our total asset turnover. How efficient we are with our assets. Cool. That's why we talk profitability and um and efficiency above. So when can we get a negative are away? Well that's the same thing when we have a negative a net loss. Right? Because we can't have negative sales sales is always a positive number. We can't have negative average total assets. That doesn't make sense either. Right? We're always gonna have some positive assets only Net income can be a negative number. So that implies that we have a net loss. So if you see a net loss, that's generally not a good thing, right? We want to be making money, not losing money. Cool. So why don't we go ahead and calculate some are away? Let's use this new information and calculate our away, uh, by using profit margin and total asset turnover. Cool. You guys go right ahead into the problem and you try and solve it before watching the next video.

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Problem

Problem

XYZ Company had a profit margin of 8.8% and total asset turnover of 0.77. What is XYZ's Return on Assets?

A

6.78%

B

0.07%

C

11.43%

D

9.57%

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Problem

Problem

A company had a profit margin of 6.1%. The company's net sales were $3,600,000 and Cost of Goods Sold was $600,000. If total assets were $3,450,000 at the beginning of the year and $4,210,000 at the end of the year, what is the company's return on assets?