We commonly use a particular phrase when formally weighing a decision to expend funds for a particular purchase or capital expenditure. "Return on Investment" (ROI) is often invoked to compare the perceived benefit to the expense of achieving it, usually considered to be cash. We may even be able to come up with a tangible dollar value of the benefit, but then what to do with it?
Is it enough to simply say that it is higher or lower than the expense? What if the benefits are more intangible? While this is a useful exercise to evaluate several options, the ROI concept has a deeper meaning to accountants and our more financially minded clients. It is advantageous to recognize the different methods of calculation and when each may be more appropriate than another. Even more important is the insights that the formula provides to the management of the firm.
In a short-term, project-scale environment, many decisions center around resource management, technology solutions, or potential deviations from the original project scope. However, the analysis becomes more complex as the time scale increases, as the time value of money becomes more significant, or as more options are considered. The difficulty of analyzing corporate-wide decisions also increases exponentially as we continually add to the number of variables and intangible benefits in play.
One of the highest-level examples of this is a firm’s valuation, especially in the case of its acquisition by another entity. Another is the evaluation of a firm’s efficiency in utilizing its assets to produce revenue. It should be noted that there are many examples of ROI in the production of goods, but it is less prevalent in the evaluation of service providers such as the A/E/C industry. Nevertheless, the insights that this financial tool provides are quite useful in analyzing a firm’s activities over time, especially when looking at a number of years.
Accountants have their own, formal definition of ROI, and it may be substantially different than what you are intuitively familiar with. There are actually a few different definitions, with minor changes in terms, and again, they are used for different purposes. If you have not had experience with accounting and don’t remember your economics courses, fear not. For now, we will consider two of the most common. The first is a simple ratio:
ROI = Net Income / Average Assets
The other is algebraically the same, but includes sales (or gross revenue) to highlight additional measures of efficiency (margin and turnover). It was developed by the DuPont corporation, and has been identified with the company name ever since. DuPont ROI is:
ROI = (Net Income / Sales) x (Sales / Average Assets)
Without delving into the details of these equations, there are a few important things to learn from them. The first should be a realization that the cost of any given benefit is usually not strictly a cash expenditure. Rather, success will depend on how well the existing assets (hardware/software infrastructure, physical location, and implements of production) are put to use to generate revenue. Another insight is that a single calculation of ROI is usually insufficient to determine anything, except against industry benchmarks (which are of dubious quality). It is important to perform this analysis over time to observe and explain trends for any given firm. Finally, what is this number really good for?
It should be apparent that a higher number is generally better, but this is only true under certain conditions. For a given asset value, higher revenue is clearly good. However, assets are not constant over time. For example, as the firm earns additional revenue over its total expenses, it realizes a profit. The money is then usually either distributed as bonuses or dividends, or it is incorporated into the balance sheet as increased assets. If invested back into the company, it is expected that additional growth will result, with new physical assets being purchased with the cash to further increase revenue and maintain a steady ROI.
With these insights as a starting point, it should be apparent that it is beneficial to learn how ROI and other financial tools can be used to evaluate and properly manage your firm’s long-term cash flow.
Jason Burke, P.E., works for Allied Engineering in Billings, Mont.
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