Insights on Industry Roa’s

Insights on Industry ROA’s

Beyond the normal analysis of ROA as a component of ROE (ROA times Total Assets/Equity equals ROE), an article by Selling and Stickney* provides some interesting insights for industry analysis based upon an analysis of the two components of the ROA ratio (profit margin and total asset turnover) and what these two components signal regarding the industry strategy. Given the two components of the ROA, it is possible to graph each of these values as shown in Exhibit 13A.1 and determine what each component contributed to the ROA at the point of intersection. As shown, it is possible to draw a constant ROA curve, which demonstrates that it is possible to achieve an 8 percent (or 4 percent) ROA with numerous combinations of profit margin and asset turnover. The particular combination of profit margin and asset turnover is generally dictated by the nature of the industry and the strategy employed by management. For example, many industries necessarily require large capital inputs for equipment (e.g. steel, auto, heavy machinery manufacturers). Therefore, the asset turnover is necessarily low, which means the profit margin must be higher. The firms in such an industry are typically in the upper left segment of the graph (Segment a), and improvements of ROA in these industries are derived by increasing profits margins because it is difficult to increase asset turnover. In contrast, industries that have commodity-type products (e.g., retail food, paper, industrial chemicals) generally have low profit margins and succeed based upon high asset turnover. These industries are generally in the lower right segment of the graph (Segment c) and they attempt to improve their ROA by increasing their asset turnover rather than the profit margin (i.e. they are constrained by price competition). Industries in the middle segment (b) are in a more balanced position and can attempt to improve the ROA by increasing either the

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