All right. So we've learned about the return on assets before, now we're going to decompose that ratio a little bit and get better information. Let's check it out. Alright. The return on assets, remember ROA, it measures the income a company earns based on the amount of assets it maintains. So we'll review that ratio in a second. Just remember that ROA, well, it was a common well, we learn about 2 things with it. We learn 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 ROA using 2 other ratios. You might have learned about these already. If not, you're going to learn about them here. Cool. So this gives us a little more information on how we derive our ROA and how we decompose it. So let's check it out. Remember that ROA, we learned it as net income over average total assets. So when we first discussed ROA, that's how we learned it. Net income divided by average total assets. Well, we're going to break it up into 2 ratios now. The ROA is going to be equal to the profit margin times the total asset turnover, all right? So those are 2 other ratios that we learn about. And when we multiply them together, it gives us our return on assets.
So our profit margin is this first ratio. Net income divided by net sales. That 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 when we sell something to a customer, what we got to pay for it, cost of goods 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 got to keep maintain a level of assets for the business to function properly and how do we turn those assets into sales, right? So total asset turnover tells us how many dollars of sales we earn per dollar of total assets owed.
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 ROA. 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. Well, 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? Well, notice what it does tell us. It tells us how we can increase our ROA. Now we have two ways to increase our ROA. First, we can increase our profit margin, right? By increasing our profit margin, our ROA 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 ROA, we have 2 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 I said profitability and efficiency above. So when can we get a negative ROA? 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 going to have some positive assets. Only net income can be a negative number, so that implies that we had 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 ROA? Let's use this new information and calculate ROA 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.
