The Importance Of Roi Essay

1663 words - 7 pages

72056_CH01I

3/13/02 11:02 AM

Page 1

CHAPTER 1

The Importance of Return
on Investment: ROI
A fter reading this chapter, you will be able to

• Understand how owners view profitability
• Compare the profitability of two companies
• Calculate a return on investment using information about
profit and investment

he owners of a company and the company’s creditors share a similar goal: to increase wealth. They are thus very concerned about
profitability in all phases of operations. Creditors are specifically
concerned that the company use its resources profitably so that it can
pay interest and principal on its debt. Owners are concerned that the
company be profitable so ...view middle of the document...

Fortunately, accounting has.
How do we measure profitability, and how do we determine standards?
Is it enough for managers to report that earnings for the year are some
amount such as $500,000? Earnings are determined by subtracting a
company’s business expenses — salaries, interest, the cost of goods sold,
for example — from its revenues from sales, investments, and other
sources.
Suppose that a company income statement is composed of the following:
Imaginary Company Income Statement
for the Year Ended December 31, 2002
Sales
Expenses
Profit

$25,000,000
(24,500,000)
$500,000

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The Impor tance of Return on Investment

Our company has made half a million dollars! Does this mean that
company managers have performed well? Probably not, because for sales
activity of $25,000,000, owners, creditors, and top management would
expect a higher profit: $500,000 is only 2 percent of $25,000,000.
Business people expect that profit must be linked to activity if we are
going to properly measure the adequacy of a company’s profit or judge
the efforts of a company’s management.
Suppose Imaginary Company instead had the following income
statement:
Imaginary Company Income Statement
for the Year Ended December 31, 2002
Sales
Expenses
Profit

$3,125,000
(2,625,000)
$500,000

It looks like the same half a million, but as we look at the relationship
between profit and activity, where $500,000 in profits is generated by
sales of $3,125,00, we can see that in this scenario the profits are 16 percent of sales.
Still, if we are going to draw conclusions about the profitability, we
need to know more than the absolute dollar amount of profit ($500,000)
and the relationship between profit and activity (16 percent in our example).We need to know something about how much money we are earning relative to our investment.

What Is Return on Investment?
Let’s suppose that the management team for the company represented
by our second income statement, with sales of $3,125,000 and profits of
$500,000, runs a company with assets — plant, equipment, inventories,

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ESSENTIALS of Corporate Per formance Measurement

and other items — worth $20,000,000. Does this new information
change our opinion of the performance of the management team? Of
course it does: $500,000 is only 2.5 percent of $20,000,000. A 2.5 percent return on an investment of $20,000,000 is not acceptable! Owners
would be better off with their funds invested in treasury bills (T-bills) or
even in a savings account — the return would be better, and there would
be no risk. A company must generate a much higher return than T-bills
or savings accounts to justify the risk involved in doing business. As our
example shows, return on investment, or ROI, is calculated as follows:
ROI

profit
investment

ROI

$500,000
$20,000,000

0.025, or 2.5 percent

Let’s...

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