The Importance of ROI Metrics
The Importance of ROI Metrics
The return on investment (ROI), also called return on capital employed (ROCE), is the amount of gain a company earns on spending a certain amount of money (referred to as investment or capital). This gain will be the result of operations undertaken by the purchase and use of assets from the investment. Metrics related to finances are called ratios.
Ratio Analysis
Ratio Analysis, the term used for the analysis of such metrics, is an important feature of business analysis. It is with the use of such ratios that an investor is able to decide which business to put his money in. For a small business, having good ratios is even more important as they will help it obtain the much-needed credit from banks and finances from investors. There are many ratios that may be calculated and compared. However, it must be noted that the comparisons should be made with comparable information only. For example, the data of a textile mill is not comparable with that of an electric supply company.
For Investors
Return on investment is calculated as the annual profit divided by the total investment made. It may also be calculated by dividing the profit with the net assets (assets minus liabilities) of the company. For an investor, this metric is very useful. It helps him decide which company to invest in. Having a higher ROI means the company will give him a higher return per dollar invested; thus, giving an overall higher profit when compared with other companies. However, using just ROI is not sufficient. Other metrics must also be used as well, such as Debt to Equity Ratio and dividend yield.
For Management
The management scores its performance using many different methods. One of these methods includes profits. However, a profit amounting to hundreds earned from thousands of dollars is poor performance. Therefore, the management of any business will look to ROI as a better evaluation technique for their operations. A higher return will mean that they are more efficient with the finances and assets they have and are able to add more value for the shareholders. This will promote motivation level and may make them eligible for bonuses.
Interpretation
While the metric is important for the company and the investor, proper interpretation is very important. A false interpretation may influence the parties to make a wrong decision. While it may be thought that having an ROI of more than one is good since it means the company is in profit, the figure has to be compared to the ROI of other successful companies in the same industry. This comparison is what makes the ratio analysis complete as both the investors and management are able to create a benchmark, compare the ROI of the company and draw conclusions.
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