Question

Write an overview of the Return on Investment topic and a review of its historical roots

Answer 1

Return On Investment (ROI) is a measure of the net income associated with a project compared to the total monetary investment in the project.

It is formulated as ROI= Net Income after tax/Total Investment.

It is compared with the industry benchmark, with peers in the same industry or also compared from year to year.

Instead of calculating ROI as a single number born out of merely 2 figures , Net Income & Total Investment, more meaning can be found out by analysing teh ROI , the DuPont way, ie. an analysis involving three important performance elements or roots , namely, profitability measured by profit margin, operational efficiency measured by asset utilization or total asset turnover and financial leverage or the equity or investment multiplier .

Under DuPont,

ROI = Net Income/Investment is spread out as

ROI=(Net Income/Sales)*(Sales/Total Assets)*(Total Assets/Total Investment or owner's equity)

Ie. ROI= Profit Margin*Total Assets Turnover*Equity Multiplier(or Financial leverage)

The first root shows the profit compared to sales revenues.

The second one throws light on the utilisational efficiency of the assets employed--ie. $ sales generated per $ of assets employed.

The third root--equity multiplier indicates the extent to which the total assets are financed by the investors funds or equity----from which one can also find the level of debt financing in the above asset-acquisition.

Thus ROI depends on (Efficiency in generating profits from sales)*( Efficiency in generating sales from assets)*(Amount of assets generated per $ of equity)

& by analysing the roots , comparing with peers or previous years' figures, the management can pin-point deficiencies , concentrate and initiate measures to improve performance & efficiency in a focussed manner.

Here also, Profit Margin can be further broken down to EBIT /Sales*(1-Tax Rate) to study the operating margin achieved. By doing this , also the quantum of interest expenses, on outside borrowings ,other the money invested can be known.

Thus ROI when analysed systematically , from its roots, will provide immensely valuable, in-depth & accurate insights into the performance of the business covering almost all important areas, that are capable of bettering the company.