Return on Investment Calculation and Analysis
Return on Investment Calculation and Analysis
Return on investment (ROI) is a very important and popular ratio used to measure a firm's profitability. ROI describes the rate of return that management was able to earn on the firm's assets for a given period of time. Hence, this ratio is sometimes referred to as return on assets. ROI is calculated using data reported in a firm's financial statements. In its most basic form, ROI can be calculated by dividing a firm's net income (amount of return) by its average total assets (amount invested) in a fiscal period.
Return on investment = Net income / average total assets
Typically the fiscal period for ROI calculations is one fiscal year. Note that since net income was earned during the entire fiscal period we must calculate ROI using the average total assets that were used to generate that income during the fiscal period. Average total assets are estimated by averaging the assets reported at the beginning and the end of the fiscal period. It would be less accurate, and perhaps misleading, to only consider the assets reported at the end of the fiscal period - especially if the firm's assets can vary greatly over time.
Because ROI is a ratio, it can be successfully used to compare the performance of firms of unequal size. To illustrate, let us consider two firms: firm Alpha and firm Beta. Firm Alpha is a large firm which reported net income of $4 million last year while firm Beta is a relatively smaller firm that reported net income of $1.5 million during the same period. At first glance, it would appear that firm Alpha is a much more successful and profitable company. But what happens when we look a little deeper and consider the assets that each firm's management team had at its disposal to generate the net income? Firm Alpha reported average total assets of $130 million last year while firm Beta reported average total assets of $15 million. If we divide the net income of each firm by its average total assets we see that firm Alpha's ROI last year was approximately 3% while firm's Beta's ROI was 10%! Our original assumption was quite incorrect! Things get even more interesting if we analyze the trend of the ROI for each company over the last several years. Firm Alpha's ROI for the years 2005 to 2010 were: 8%, 6%, 4%, 2%, and 3% while firm Beta's ROI for the years 2005 to 2010 were: 7%, 8%, 9%, 9%, and 10%. Firm Alpha's ROI shows a troubling downward trend in profitability while firm Beta has been steadily increasing its profitability. This illustration shows not only the importance of ROI but also the value of trend analysis when judging a firm's profitability. Examining the trend of a ratio can be much more illuminating than examining a ratio for only one fiscal period.
It should be noted that there are many ways of defining the amount invested and the amount of return when calculating ROI. One can define the amount invested as average total assets and the amount of return as net income as in the example above. However, some financial data users prefer to define the amount invested as average operating assets and the amount of return as operating income.
Return on investment = Operating income / Average operating assets
Operating assets are only those assets that are used in operations and operating income is earnings before interest and income taxes. By excluding assets and expenses not directly related to operations it is possible to gain a more refined measurement of the operating results of the firm.
Another popular method to calculate ROI is to use an expanded calculation model known as the DuPont model. This model measures the effects of profitability from sales and the utilization of assets on ROI.
Return on investment = (Net income / Sales) x (Sales / Average total assets)
The first term, net income/sales, is known as margin and it measures the amount of revenue that contributes to the firm's bottom line. The second term, sales/average total assets, is known as asset turnover and it measures how efficiently the firm's assets are used to generate revenue. The DuPont model allows management to consider efficient utilization of assets to be an important factor in determining ROI.
While there are many methods to calculate ROI, each with its own benefits and drawbacks, it is important to be consistent in the definition of the amount of return and the amount invested when calculating ROI. Consistency in ROI calculation allows for meaningful analysis of the trend in ROI and is more important than the actual result of the ROI calculation for a given year. Also, due to the various methods used to calculate ROI, it is important for the financial data user to understand how the terms of the ROI calculation were defined when presented with a firm's ROI ratio.
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