Return on Investment (ROI): Definition, Meaning and Use
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Revised 2013-05-21.
Return on investment (ROI) analysis is a popular financial metric for evaluating the financial consequences of individual investments and actions. Several different metrics are in fact called by that name, but the best known is the metric presented here as simple ROI. For more on a special use of ROI that considers only the cash (or capital) portions of larger transactions, see the encyclopedia entry cash on cash analysis. For more on other ROI-like metrics that measure a company's ability to earn from capital assets and equity, see the entry on profitability metrics.
As
a cash flow metric, simple ROI compares the magnitude
and timing of investment gains directly with the
magnitude and timing of costs. A high ROI means that gains compare favorably to costs.
ROI is now well known as a general purpose decision metric for evaluating capital acquisitions, projects, programs, and initiatives of many kinds, as well as more traditional financial investments in stock shares or the use of venture capital. Popularity notwithstanding, the metric is often used by those with a limited understanding of its weaknesses and its unique strengths.
ROI is sometimes said to measure profitability. That description is accurate and useful. Some business people, however, borrow a term from the field of economics and say that it also measures efficiency in the use of funds. That usage is arguably less informative because the same term—efficiency—is also used to describe what is measured by quite a few different financial metrics, including
internal rate of return (IRR), payback period, inventory turns, and return on capital employed.
• The ROI concept and the meaning of return on investment
• Calculations for cash flow and investment analysis
• Comparing competing choices: Cash flow stream analysis
• Financial metrics compared and contrasted
• Evaluating business case scenarios
• Other ROI metrics
The ROI concept and the meaning of return on Investment
The
meaning of return on investment is implied in its name.
The metric addresses questions like these: What do we receive for what we spend? Do expected returns outweigh the costs? Do the
returns justify the costs?
Most forms of ROI compare returns to costs by constructing a ratio, or percentage. Usually, a calculated ratio greater than 0.00 (or a percentage greater than 0%) means that returns are larger than costs. A negative result means the opposite—costs outweigh returns. When potential actions compete for funds, and when other factors between the choices are truly equal, the investment—or action, or business case scenario—with the higher ROI is considered the better choice or the better business decision.
One serious problem with using ROI as the sole basis for decision support is that the calculated result by itself says nothing about the likelihood that expected returns and costs arrive as predicted. That is, by itself ROI says nothing about uncertainty or risk. It simply shows how returns compare to costs if the hoped for results arrive. (The same is also true of other financial metrics such as net present value, or internal rate of return.) For that reason, a prudent analyst will also try to assess the probabilities of different ROI outcomes, and wise decision makers will consider both the magnitude of the metric and the risks that go with it.
Decision makers will also expect practical suggestions from the analyst on ways to improve return on investment by reducing costs, increasing gains, or accelerating gains (see the figure above).
Calculations for cash flow and investment analysis
Return on investment is frequently derived as the “return” (incremental gain) from an action divided by the cost of that action. That is the "simple" version of this metric as used for business case results and other forms of cash flow analysis. For example, what is the ROI for a new marketing program that is expected to cost $500,000 over the next five years and deliver an additional $700,000 in increased profits during the same time?
In other words, the metric is simply the incremental gains divided by total costs.
Results such as the 40.0% figure above can be interpreted usefully when both the gains and the costs of an action are known and clearly follow from the action. In complex business settings, however, it is not always easy to match specific returns (such as increased profits) with the specific costs that bring them (such as the costs of a marketing program), and this makes the metric less trustworthy as a guide for decision support. ROI also becomes less trustworthy when the cost figures include allocated or indirect costs, which are probably not caused directly by the action.
Comparing competing choices: Cash flow stream analysis
Several different financial metrics take an investment view of an action or decision, which means essentially that each metric compares the timing and magnitude of returns to the timing and magnitude of costs. However each of the major cash flow metrics (ROI, internal rate of return IRR, net present value NPV, and payback period), approaches the comparison differently, and each carries a different message. This section illustrates ROI calculation from cash flow streams for two competing actions and the next section ( Financial metrics compared and contrasted) compares the differing and sometimes conflicting messages from different financial metrics.
Consider two five-year investments competing for funding, Case A and Case B. Which is the better business decision? Analysts will look first at the net cash flow streams expected for each case:
| Now | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total | |
|---|---|---|---|---|---|---|---|
| Net Cash Flow A | –100 | 20 | 30 | 40 | 70 | 80 | 140 |
| Net Cash Flow B | –100 | 70 | 60 | 40 | 30 | 20 | 120 |
Two aspects of the data are apparent at once: (1) Case A has the greater overall net cash flow over 5 years, but (2) the timing of cash flows in each case is quite different. The timing differences are even more apparent in a net cash flow graph:
Generally, important business decisions should not be made on the basis of just one financial metric. To
answer the question, "Which is the better business decision?" the analyst will want to examine both sets of cash flow results with several
financial metrics, including ROI, NPV, IRR, and Payback period. This section and the next compare Cases A and B on these different metrics.
There is a serious disadvantage to net cash flow stream A, however, that is not apparent in the net cash flow figures themselves. Among these metrics, that disadvantage is revealed only by ROI.
In order to calculate ROI, the analyst needs to see both cash inflows and cash outflows for each period (year) in addition to the net cash flow. The tables below show these figures for each case, including also cumulative cash flow and simple ROI for the cash flow stream at the end of each year.
For Case A ...
| Case A | Now | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total |
|---|---|---|---|---|---|---|---|
| Cash Inflows A | 0 | 90 | 100 | 125 | 145 | 155 | 615 |
| Cash Outflows A | –100 | –70 | –70 | –85 | –75 | –75 | –475 |
| Net Cash Flow A | –100 | 20 | 30 | 40 | 70 | 80 | 140 |
| Cumulative CF A | –100 | –80 | –50 | –10 | 60 | 140 | |
| Simple ROI A | –100.0% | –66.7% | –44.1% | –25.9% | –8.0% | 7.0% |
For Case B...
| Case B | Now | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total |
|---|---|---|---|---|---|---|---|
| Cash Inflows B | 0 | 100 | 90 | 75 | 50 | 40 | 355 |
| Cash Outflows B | 100 | 30 | 30 | 35 | 20 | 20 | 235 |
| Net Cash Flow B | –100 | 70 | 60 | 40 | 30 | 20 | 120 |
| Cumulative CF B | –100 | –30 | 30 | 70 | 100 | 120 | |
| Simple ROI B | -100.0% | –23.1% | 18.8% | 35.9% | 46.5% | 51.1% |
Simple ROI for each case, in each period, appears in the bottom row of each table. Applying the cash flow formula above to these data, the metric for, say, Year 3 of case B is given as
Using simple ROI as the sole decision criterion, which choice, A or B, is the better business decision?
- Considering the 3-year results from each case, clearly B's ROI of 35.9% is better than Case A's ROI of -25.9%.
- Considering the 5-year results, B still has a large advantage with an ROI at 51.1.2%, vs. 7.0% for A's five-year result.
Why does ROI alone among the financial metrics here give such an advantage to B, even though A has a larger 5-year net cash flow ($140 vs. $120)? Note that only ROI considers cash inflows and outflows each year, whereas the other metrics use only the annual net cash flow figures. In this example, A has much large inflows and much larger outflows than B. That difference is "masked" or hidden from the other metrics. A's larger total costs, for instance ($475 vs $235) have to be budgeted and paid, regardless of the size of incoming cash flows. The business decision maker may simply be unwilling or unable to do so.
The example also illustrates two other important points to keep in mind about this ROI and decision support:
- For most business investments or actions, there is not a single ROI independent of the time period. Important actions in a complex business environment typically have financial consequences extending several years or more, and the result can be different every year (or other period). The resulting ROI is not defined, that is, until the time period is stated.
- The standard advice usually repeated for decision support is this: "Other things being equal, the cash flow results with the higher ROI is the better business decision." However, the condition "other things being equal" almost never really applies. When comparing action choices with ROI, it is usually a very good idea to consider other financial metrics as well (as illustrated below).
As a final consideration in calculating the metric, note that some financial specialists prefer to derive the result from a discounted cash flow stream, that is, from net cash flow present values. In situations where larger costs come early and larger gains come later, discounting typically leads to a lower ROI than the same calculation performed on non discounted cash flow figures. That is because the discounting has a greater impact on the later large gains than it does on the early larger costs. Using discounted cash flow figures to calculate ROI leads to a more conservative, less optimistic result. There are "pros" and "cons" to both the discounted and non discounted approaches, and the business analyst should be sure to understand which approach is preferred by the organization's financial officers, and why.
Financial metrics compared and contrasted
The different natures of example Cases A and B above are also apparent in a line graph of cumulative cash flow for each case (cumulative cash flow for a period is the sum of all net cash flows through the end of the current period). This is the fourth data row in each table above. (Cumulative cash flow and payback are explained more fully in the encyclopedia entry for payback period). In fact, some people call cumulative cash flow graphs such as these, "return on investment curves."
Which example case, A or B, is the better business decision? In this section, you should see that each choice has points in its favor, compared to the other, and that ultimately decision makers will have to weigh ROI results along with several other metrics, to decide which is best for their organization at the present time. Here are some of the points to consider:
- Total Net CF: Case A outscores B in terms of 5-year net cash flow, $140 to $120. This is a point in favor of Case A.
- ROI: Case B has the higher 5-year result (51.1% for B vs. 7.0% for A). That is a point in B's favor. In this case, B's result on this metric is in fact larger than A's for every year of the 5-year investment.
- Future performance: The cumulative curves above only cover 5 years, but if the resulting inflows and outflows are expected to continue beyond 5 years, the curves point to two different futures. By Year 5, A's cumulative cash flow curve is heading skyward, while B's appears to be leveling off. If there is reason to believe these patterns will continue, this is also a point in favor of A.
- Payback period. The curves above show roughly the point in time when the cumulative cash flow "breaks even," that is, when cumulative incoming returns exactly balance cumulative outflows. This point in time (point on the horizontal axis) is payback period for each case (see payback period). The payback period for B is 1.5 years while A's payback period is 3.14 years. Thus B "pays for itself" in half the time of A. The shorter payback period is preferred because it means invested funds are recovered sooner and available for use again sooner. The shorter payback period is also viewed as less risky than the longer payback. These are points in favor of B.
- Net present value (NPV): Using a 10% Discount rate, B has a net present value (NPV) of 76.18, while A's NPV is 70.51. With the time value of money rationale, this means that B is worth more, today, than A, even though A will ultimately (in 5 years) return more funds. This is a point in favor of B.
- Internal rate of return (IRR): Internal rate of return (IRR) is the interest rate that produces an NPV of 0 for a cash flow stream (see Internal rate of return for a complete overview of what this means and why it can be important). Case A has an IRR of 28.9% while B's IRR is 44.9%. Roughly speaking, financial officers will view a potential result with an IRR above their cost of capital as a net gain. When proposals are competing for funds, of course, the one with the higher IRR is preferred. This is a point in favor of investment B.
Based on the financial metrics reviewed above, which action, A or B, is the better business decision? Clearly there is no "one size fits all" answer, except to say that ROI is one factor decision makers and planners will consider, but they will consider other factors as well and give different "weights" to the different financial metrics above, based on (a) the company's business objectives, and (b) the current situation.
Evaluating business case scenarios
Which business case scenario represents the best business decision? Which action scenario should the analyst recommend? ROI and other cash flow metrics (Net cash flow, NPV, IRR, and Payback period) are often used to address such questions.
Financial business case analyses typically look forward in time, projecting estimated cash inflows (benefits) and cash outflows (costs) expected under each of two or more action scenarios (Note that one of the scenarios may be a "Business as usual" or "Do nothing" scenario). The three-panel figure at left is a very simple example of the way these cash flow estimates can be summarized.
Each of the top two panels represents the full value of projected cash inflows or outflows for several "benefit" and "cost" items. For comparing the two scenarios and for asking ROI questions, it is helpful also to construct an incremental cash flow scenario, as shown at bottom. The bottom panel holds item-by-item differences, or incremental values between "Proposal Scenario" and "Business as Usual" scenario cash flow. (For more on business case cash flow scenarios, see the encyclopedia entry business case cash flow statement or the book Business Case Essentials.)
Notice that only the figures in the bottom panel, the incremental cash flow, are appropriate for addressing the ROI questions. The incremental statement figures represent inflows and outflows directly attributable to taking the action (in this case, implementing a proposal). On the other hand, figures in the full value scenarios may result from many causes besides taking the action proposal.
What is the three-year result for implementing the proposal scenario (compared to staying with "Business as Usual")? Using figures from the incremental cash flow statement:
ROI = (Gains - Costs) / (Costs)
= (4,280 – 2,110) / 2,110
= 102.8%
The projected three-year result of 102.8% is very attractive. Before unequivocally recommending taking the action, however, the prudent analyst will also . . .
- Perform a risk analysis, attempting to estimate the probability that forecast costs and returns actually appear as predicted, as well as the probabilities that other, quite different results appear. In business investing (as in gambling), it is good practice to weigh potential rewards against the risks before taking action.
- Consider thoroughly other possible uses of the additional funds that would be invested in the action.
Other financial metrics are also called "ROI"
In financial statement analysis—where analysts assess the financial health and business performance of companies—“Return on Capital Employed,” “Return on Total Assets,” “Return on Equity,” and “Return on Net Worth,” are sometimes called “return on investment.”
In still other cases, where the focus is cash flow analysis, the term sometimes refers to cumulative cash flow results over time. And, some people refer to other cash metrics as "ROI," such as average rate of return and even internal rate of return.
Regarding terminology, as noted above, forms of simple ROI that consider only the cash portions of larger investments are sometimes called cash on cash analysis or return on invested capital (ROIC).
In brief, several different return on investment metrics are in common use and the term itself does not have a single, universally understood definition. Therefore, when reviewing ROI figures, or when asked to produce one, it is good practice to be sure that everyone involved defines the metric in the same way.
By Marty Schmidt. Copyright © 2004 - Solution Matrix Limited and 
Marty Schmidt+. All Rights Reserved.
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