Question

“ROI can be compared with the rate of return on opportunities elsewhere, inside or outside the company” Discuss the statement. Similarly, compare and Contrast different methods of Financial Performance Measurement.

Answer 1

First lets explain what is ROI or Return On Investment.

Return on Investment (ROI) is a performance measure, used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments. ROI measures the amount of return on an investment, relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.

ROI is a popular metric because of its versatility and simplicity. Essentially, ROI can be used as a rudimentary gauge of an investment’s profitability. The calculation is not complicated, relatively easy to interpret, and has a range of applications. If an investment’s ROI is not positive, or if other opportunities with higher ROIs are available, these signals can help investors eliminate or select the best options.

The return on investment formula:

ROI = (Gain from Investment - Cost of Investment)/Cost of Investment

As ROI is a very flexible profitability ratio it can be easily compared with rate of return on opportunities inside or outside the company.By Calculating ROI you can better understand how well your business is doing and which areas could use improvement to help you achieve your goals.It may be used for inter firm comparison provided that the firms whose result are being compared are of comparable size and of the same industry.Using ROI can give a quick estimate of the projects net profit and can provide a basis for comparing several different projects.

Different methods of financial performance measurement are as follows.

Horizontal Analysis

Horizontal analysis compares financial results over time. A financial statement analyst compares income statements or balance sheets for subsequent years to uncover trends or patterns. While useful, but this method has drawbacks as well. For example, one-time accounting charges such as expenses for impairment, losses from natural disasters and changes in company structure can impede accurate analysis.

Vertical Analysis

Vertical, or common-size, analysis prepares financial statements that are adjusted as percentages of sales or other account category totals. This technique allows analysts to see the compositions of the different categories of financial statements. On the income statement, sales is commonly used as the reference category and is the denominator of all of the other calculations; the balance sheet uses total assets, total liabilities and total equity. The downside of vertical analysis is that it only offers a look at a single period of operations, generally a year. This can make it difficult to draw conclusions about the business over time.

Ratio Analysis

Financial analysts use a broad range of techniques that are collectively known as ratio analysis. The general procedure involves calculating various financial ratios -- such as profit margin, accounts receivable-to-sales, and inventory turnover ratios -- and comparing them to other companies or general rules of thumb. There are hundreds of financial ratios employed and even different methods of calculating the same ratios. For this reason, ratio analysis is considered to be more of an art than a science. This inconsistency is one of the technique's downfalls.

Benchmarking

A technique often used both with ratio analysis and vertical analysis is benchmarking, which computes common-size financial statements or financial ratios and compares them with other companies and industry standards. This technique is popular and is sometimes used to compare a company to its competitors. However, it is important to note that every company is different; even companies in the same industry may have very different management philosophies, goal and cost structures. As such, benchmarking can be an effective tool, but might not be appropriate for ranking or directly comparing firms.