About/Contact Info I am a business consultant for a leading North American business and [+/-] technology services company and have an MBA specializing in management.
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One of the most effective ways of assessing financial performance and making good decisions is by determining your return on investment, or ROI. A good understanding of the ROI will help you go a long way in making the right choices in business and in life. Here’s what it is, and how you can benefit from knowing how to figure it out.
The ROI is a financial formula used to determine, as its name would imply, the return on a given investment. In other words, it is used to calculate how profitable one particular investment choice is compared to other possible investment choices. Here is the formula:
ROI = (Gain from Investment – Cost of Investment) / Cost of Investment
Here’s a simple example of how this formula is used. Suppose you’re faced with a decision on whether to invest in ‘Decision A – Buy New Equipment’ or ‘Decision B – Upgrade Old Equipment’, and you have already determined your cost-benefit analysis that the potential gains and costs of each decision.
Suppose that the potential gain from Decision A – Buy New Equipment is $10,000 and the cost of the new purchase is $2,500. The ROI in this simplified example would then be: ($10,000-2,500)/2,500, or 3.0.
Now suppose that in the alternative decision, Decision B – Upgrade Existing Equipment, the anticipated gain from the decision is $8,000 and the cost of the upgrade is $1,500, the ROI of this alternative decision would be: $6,500/1,500, or 4.33. The decision to upgrade the existing equipment yields an ROI significantly higher (44%) than the decision to purchase new equipment, thus the upgrade decision would be the choice to make.
If you’re not comparing two or more decisions, but only looking for whether or not to make one particular decision, the ROI formula would indicate that it’s wise to proceed only if the ROI is greater than zero. But this makes sense, since you’d never want to invest in something which costs more than it yields, would you?
If you’re new to understanding financial performance formulas, you might want to begin by reading a quick primer on financial ratios.
Regardless of the industry you operate within, if you want to truly identify your company's competitive advantage, you need to be able to understand the strengths and weaknesses of your business, and how the strategies you have chosen affect your profitability.
It's simple enough to list all of your company's strengths and weaknesses, but to do this effectively, you must benchmark, or compare, these items against those of either your competitors or even against your own past performance. If you're new to the concept of benchmarking, there is a helpful resource on what it is, and how to do it, which can be found here.
By comparing and analyzing your company's performance in this way, you can begin to understand which of your management decisions have been the most profitable to your business, and which have missed the mark. In this way, you can begin to focus in on your company's return on investment (ROI), and look for ways to make the decisions that bring the highest return thus increasing your profitability.
Whether you’re looking at your own company’s own performance and financial situation, or at that of other companies for opportunities to invest, financial ratios are a very useful thing to understand. This article will serve as a guide to understanding some key financial ratios such as: current ratios, quick ratios, debt and debt-equity ratios, as well as asset turnover and profitability ratios.
Remember that while financial ratios provide a measure to benchmark one company with another, they do not tell the whole story of the company – true performance information must also take into account the management practices of the firm.
Liquidity – Current Ratio
The current ratio, also known as the working capital ratio, is a measure of a firm’s ability to satisfy its short-term financial obligations. Simply put, this is the ratio of the company’s current assets to its current liabilities. A high current ratio (relative to that of similar companies) indicates a greater ability of your company to pay back its short-term debt obligations.
Current Ratio = Current Assets / Current Liabilities
Liquidity – Quick Ratio
The quick ratio is perhaps a more reflective measure of a firm’s liquidity. Unlike the current ratio this measure only includes assets which can be sold off quickly. (The current ratio on the other hand, includes such items as inventory, which often takes long periods of time to liquidate). Thus, the current assets considered in the quick ratio are cash, accounts receivable and notes receivable; the amount of inventory is taken out of the equation.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Financial Leverage – Debt Ratio
In addition to short-term liquidity measures such as the ones above, it is of course also important to examine the long-term solvency of the company with financial leverage ratios such as the debt ratio and the debt-to-equity ratio. The debt ratio is equivalent to a firm’s total debt (e.g. its long term debt obligations such as long-term leases, etc) over its total assets.
Debt Ratio = Total Debt / Total Assets
Financial Leverage – Debt-Equity Ratio
The debt-to-equity ratio measures how much debt a firm is carrying relative to its total equity, or total net worth. This is the ratio of the total dollars attributed to the firm by creditors (the total debt) over the total dollars held by owners (total equity). A rising D/E ratio indicates the firm is becoming more highly leveraged by relying more upon debt to finance its operations, and that any new debt should be limited and better controlled.
Debt-Equity Ratio = Total Debt / Total Equity
Asset Turnover – Inventory Turnover Ratio
The inventory turnover ratio measures the firm’s ability to move its products. Keeping inventory for an excessive period of time creates extra costs, thus having a faster inventory turnover can lead to a more positive cash flow and a reduction in inventory storage costs.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory (for the period)
Profitability – Gross Profit Margin
The gross profit is a measure of the total sales, minus the cost of the goods sold over the total sales. It is a useful measure in determining the percentage of profit per sales.
Gross Profit Margin = (Total Sales – Cost of Goods Sold) / Total Sales
Profitability – Return on Assets (ROA)
The return on assets ratio measures how the company’s income is being derived by its total assets. In other words, this ratio shows you how well the company is using its assets (e.g. machinery, land, equipment, etc) to increase its profitability.
ROA = Net Income / Total Assets
Profitability – Return on Equity (ROE)
Like the ROA ratio, the return on equity ratio measures how the company is earning its profits. Unlike the ROA which uses the total assets as a measure, this ratio shows how profitability is being derived from shareholder equity. The ROE measure is thus an important one for the company’s shareholders; it shows them the number of dollars of income earned by the firm for every dollar invested in stock.
ROE = Net Income / Total Equity
Hopefully this primer was helpful in explaining some key financial ratios. In the coming weeks, there will be more ratios uncovered here for the purpose of conducting investment analysis. Stay tuned.
In his most recent article, "Forget Formulas: How Managers are Fooled in their Search for Success," author Phil Rosenzweig writes of the over-importance many business leaders place in following cookbook style recipes for success offered by well-regarded books such as Built to Last and Good to Great.
Rosenzweig writes of the example of K-Mart in the early 1990s; the company had met most of it's own performance measures such as improving its inventory turns, making better use of central purchasing to reduce its costs, using point-of-sale information technology and making its supply chain management more efficient. And yet, despite these improvements and K-Mart's focus on its own performance metrics, the company had faltered by the end of the 1990s, losing its market share to rivals Wal-Mart and Target.
Following formulas for business success can never ensure high performance because they "treat performance as if it were absolute rather than relative (to one's competitors)." In order to truly achieve high performance, companies (and their leaders) must be willing to take risks in order to do things better than their rivals.
True, there is a need for having a clear focus, strong values, and a concern for customer needs. But when it comes to building a high-performance, profitable company, these dimensions should never overshadow the "vital dimension" of competition.
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