There are several methods and models using in Finance for Investment and Asset Management assessments. You can find several resources and books to explain each of them and give an idea of the concepts.
In next couple of articles, I will try to analyse and give detailed information to explain them. My main aim to create a one-stop source to provide vital information we use in the hospitality industry. Therefore, I analyse, collect and use my notes created in years with some references from well-known books and reputable articles.
What is ROI?
Return on Investment (ROI) is the ratio between the net profit and cost of investment resulting from an investment of some resource. A high ROI means the investment's gains compare favourably to its cost. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiencies of several different investments. In purely economic terms, it is one way of relating profits to capital invested. (Wikipedia)
Return on Investment (ROI) is a popular financial metric for evaluating the financial consequences of investments and actions. The calculated ROI is a ratio, or percentage, comparing net gains to net costs. ROI is popular because, in this way, ROI provides a direct and easily understood measure of investment profitability.
There are several different metrics are called return on investment, or ROI, but the best known is the cash flow metric which we will focus on as Simple ROI or the Return on Investment Ratio. Like other cash flow metrics (NPV, IRR, and payback) ROI takes an Investment view of the cash flow stream that follows from an action. Each of these metrics compares likely returns to likely costs in a unique way and, as a result, each metric carries a unique message about the cash flow stream.
What does ROI concept mean?
As it states in its name this metric aim to assess the return on investment and address questions such as;
What do we receive for what we spend?
Do expected returns outweigh the costs?
Do the returns justify the costs?
What is the profitability of the investment?
The simple ROI metric answers these questions by making a ratio (or percentage), showing directly the size of net gains relative to the size of total costs.
Consequently, when total returns exceed total costs, net gains are positive, and the ROI metric is positive (greater than 0).
The opposite outcome (negative net gains) leads to a negative ROI (less than 0). Negative ROI signals, therefore, that total costs outweigh total returns and the investment is a net loss.
In summary, when different projects compete for funds, and when other factors between them are truly equal, decision makers view the option with the higher ROI as the better choice. I will explain this with examples later on.
How does it work?
ROI compares returns to costs by making a ratio of cash inflows and outflows that follow from the investment. By definition, the ROI ratio calculates as net investment gains divided by total investment costs.
With that in mind, ROI figures alone are not a sufficient basis for choosing one action over another. That is because ROI simply shows how returns compare to costs if “the hoped-for” results arrive. The ROI figure, therefore, shows expected profitability but says nothing about uncertainty or risk. Therefore, it is always advisable estimating the likelihood of different ROI outcomes and analyse/measure the risk separately for the decision-making process.
Calculating ROI for Investment Analysis and Decision Support
We will cover a different type of ROI calculations, starting from basic to complicate in this section. The basic presentation of return on investment as the return (net gain) due to an action divided by the cost of the action. That is the simple ROI version of the cash flow metric for rating investments, business case results, and other actions.
Example: What is the ROI for a marketing program that will cost £500,000 and deliver an additional £700,000 in profits over the next five years?
For simple action scenarios with only one cash outflow and one cash inflow, ROI data needs are very simple. You only need two numbers;
Simple ROI = (Gains – Investment Costs) / Investment Costs
We can apply above formulation accordingly;
Simple ROI = (£700,000 - £500,000) / £500,000 = 40%
It might look very simple and straightforward, however, the challenge is knowing which costs and which return figures to use in the formula. As a result, when the match between returns and costs is doubtful, the ROI metric loses validity as a guide for decision support. ROI validity also suffers when the cost figures include allocations or indirect costs, which are probably not due to the action.
ROI Calculations for Comparing Two Investment Options or Cash Flow Streams
On this section, we will review how ROI metrics compare two investment cases that are competing for funding. Capital Review Committees, Project Management Offices and Investors receive several projects asking for funding and ROI is an effective way of comparing competing projects base on cash flow stream. In basic terms, they will review incoming proposals and reject the project shows lesser returns and/or net loss. So, when using ROI to compare two proposals, other things being equal, decision-makers will probably choose the option with the higher ROI.
Example: There is two project which requires similar investment five-year period competing for funding. Their cash flow streams are as follows;
Let’s review our findings together for our analysis;
Project A has the greater overall net cash flow over 5 years; Total net cash flow £140K vs £130K respectively.
When we looking to cash flow timing we could see a differentiation between two cases; while Project B enjoys larger returns in the earlier years, Project A starts slowly and gradually improved. We need to understand how the timing differences impact several different cash flow metrics. We can see these differences clearly on Net Cash Flow Graph below;
To be able to understand and make an informative business decision in these two cases, we need to consider several other financial metrics such as ROI, NPV, IRR and Payback period. The purpose of the multi-metric comparison, therefore, is to show that different metrics can reach opposite conclusions in which case represents the better business decision.
It appears that Project A’s cash flow stream has a problem that is hidden by the net cash flow figures. Among these metrics, only ROI reveals this problem. Net Cash Flow values for both projects are not enough to identify underlying reason therefore, we need to analyse cash inflow and cash outflow data for each period for both projects.
For the multi-event, multi-year cases we need the following information to calculate return on investment;
The known length of the investment life.
Total investment costs (cash outflows).
The sum of returns due to the investment(cash inflows) across investment life.
ROI = ((Total Inflows to end Year X) - (Total Outflows to end Year X)) / (Total Outflows to end of Year X)
You can find above tables which includes Cash Inflow and Outflow figures as well as annual ROI calculation. To be able to have the credibility for this analysis we need to confirm that figures stated in these cash flows are due to the investment or action, and not to other causes.
Difference between Profit and Profitability
The question we aim to answer in this exercise is “Which case has the better returns compared to costs?" Some of our key findings are as follows;
Comparing Year-3 results from each case, Project B’s return of 41.0% ROI is greater than Project A’s ROI of –1.5%. Considering that all other factors are equal, Project B is the better business decision when we look at for a 3-year investment period. Project A has negative ROI results for the first 3 years.
Comparing the full 5-year results, Project B still has the greater ROI of 55.3% versus Project A’s 29.5%. As a result, when other factors are equal, Project B is also the better business decision when the 5-year investment life is in view.
There seems to be a conflict here when we consider profitability Project A has better returns; £140K vs £130K. On the other hand, Project B is more profitable 55.3% vs 29.5%!
I have mentioned earlier that there are other models such as NPV, IRR, and payback in use for analysis investments and its returns. However, Return on investment (ROI) is the only method reveals that difference. NPV, IRR, and Payback metrics are blind to that distinction because they derive from net cash flow figures.
Without ROI details Capital Review Committees, Project Management Offices or Investors will favour Project A directly based on the total return by the end of the 5-year investment period. However, when we look at the detail cash flow data we also notice that Investor need to put more money throughout the project £615K vs £365K which means more funds should allocate during the project life and this might not be the attractive or good use of resources comparing to benefits.
ROI is legitimate only when all investment costs (cash outflows) and all returns (cash inflows) are known. So, ROI should be used only when the appropriate cash flow data for calculating the metric are available.
Where and When to USE ROI?
Following above examples, we identify that ROI calculations are useful in below situations;
Simple investment scenarios with only one cash outflow and one cash inflow
Investment scenarios with multiple cash inflows and outflows across a longer investment life.
ROI would be useful and help address following questions;
Does the investment bring a net gain or a net loss?
What is the profitability of this investment?
As ROI name indicates; What is its return on investment?
Considering several competing projects, which option should we choose?
Which project is the most profitable?
Should we make this investment, "Yes" or "No"?
Where and When to AVOID ROI?
When Cash Inflow and Outflow figures are not available
When comparing investments for different time periods
Do not calculate ROI from Discounted Cash Flow PV (Present Value) figures
Several different ROI metrics are commonly used and the term itself does not have a single meaning that everyone in business understands in the same way. Therefore, when using return on investment figures, it is good practice to be sure that everyone involved understands exactly which version of the metric is.
Is there any other metrics also called for Return on Investment?
The return on investment name sometimes applies to several other metrics in financial statement analysis. Some people say ROI when referring to metrics also known as:
Return on Capital Employed
Return on Total Assets
Return on Equity
Return on Net worth
Earnings per Share
Average Rate of Return
Cumulative Cash Flow Results, Return on Investment Curve
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