Thursday, August 05, 2010

Return on Investment (ROI) Defined

ROI Defined: A general concept referring to calculate the Earnings from the Investment of Capital, where the earnings are expressed as a proportion of the outlay.

Knowing the value of ROI is important when making a business investment because it clearly demonstrates the financial gains of the proposed project, compared to the relative cost.

The Return on Investment (ROI) calculation is fairly straightforward, and is defined as the ratio of the net gain from a proposed project, divided by its total costs.

In formula form, ROI is represented as:

ROI = cumulative net benefits / total costs

The ROI calculation uses the cumulative investment costs over the analysis period, and compares this with the total savings and other tangible benefits over the same period. The ROI value is usually expressed as a percentage, multiplying the ratio by 100%.

For example, if a project has an ROI% of 200%, the expected net benefits of the project are double those of the expected costs for implementing the project. In more basic terms, every $1 invested in the project will yield $2 in net returns.

In an analysis where the costs and benefits have been properly estimated, decision makers typically look for higher percentages for ROI as an indication of risk reduction. The higher the percentage the less risk typically, because the benefits are much higher than the costs, and the project is more tolerant if costs overrun predictions, or benefits fall short of expectations.

ROI Calculation Example

To understand further, let us examine the cash flows from a sample project and the resultant ROI calculation:

ROI% = $425,000 / $175,000 = 243%

The ROI in this example was calculated by taking the Cumulative Net Benefits of $425,000 divided by the Cumulative Total Costs of $175,000. Hence, the net benefits are more than double the investment, yielding an ROI% of 243%. Every $1 invested will yield a $2.43 in net returns.

Limitations in Calculating ROI?

As a simple % calculation, ROI is easy to understand, and easy to apply to comparisons, however the ROI calculation if used as the only measure of a projects viability, has some shortcomings.
  1. The ROI formula shows the net return from investment but does not indicate the time associated with achieving the returns.
  2. The ROI calculation does not recognize that in some cases, the projects total cost and benefit value may be so small that the net benefits are not worth considering. As an example, the ROI% of a planned project might be a significant 500%, but the net benefits of $10,000 on a $2,000 investment are so small that the project is not worth comparing to the millions of dollars in benefit that most corporations are seeking. Conversely, for some projects the costs may be so high that even though the net benefit and ROI yield are high, the project exceeds a reasonable investment risk. For example, a project that costs $10 million and has a projected net benefit of $100M, yields an ROI% of 1000%, but the risk of applying $10 million to a single project might be too high for a cash strapped company. Thus background economic scenario of each situation must be considered.
  3. The standard ROI calculation typically does not use net present value terms in its calculations. Net present value calculations use the “time value of money”, which takes into account the fact that the purchasing power of a dollar received in the future is less than dollar possessed today. The ROI calculation does not take into account that many projects require up-front investments that then need to be offset by savings in outgoing years, but that these savings are not as valuable when compared to up-front costs because money in the future is worth less than today. To resolve this issue, sometimes the ROI formula includes net present value calculations for the net benefits and the costs.

The Bottom-Line

Overall, the ROI calculation provides a valuable comparison of the net benefit verses total cost, a ratio that can point towards a solution that delivers optimum financial benefits. But ROI alone is not the only indicator of performance, and should be considered with other factors such as NPV Savings, IRR, and payback period prior to making a purchase decision.

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