Unlevering the return on assets
When calculating a firm’s return on total assets (“ROA”) ratio, some investment professionals modify the ROA ratio by adding back the interest expense paid by a firm to its creditors, on a net-of-taxes basis, as follows:
Net income + i.(1-tax rate)]
Return on assets = ----------------------------------------
Total assets
Where i is the actual interest expense paid by a firm and the tax rate is a firm’s “effective tax rate” (income tax expense divided by pre-tax net income). Adjusting net income for the interest expense paid by a firm is called “unlevering net income” because the adjustment yields a measure of net income as if the firm were all equity financed (with no debt financing).
Discuss when and why unlevering ROA might produce a more useful measure of the return on assets of a firm.