Quick Tips For ROI - Return On Investment Financial Modelling

Tags: #ROI, #returoninvestment, #financialmodels, #investmentanalysis, #hospitalitycode, #whatisROI

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;

  • Cash inflow

  • Cash outflow

Simple ROI = (Gains – Investment Costs) / Investment Costs

We can apply above formulation accordingly;