ROI Isn't What You Think it Is
"Business, more than any other occupation, is a continual dealing with the future; it is a continual calculation, an instinctive exercise in foresight." - Henry R. Luce
"We need to show results, or else!"
"That deal was a loser!"
"We should have invested elsewhere."
"The boss wants it, so we're doing it."
Do these statements sound familiar? Each in its own way defines a key performance indicator ROI, or Return on Investment. But, ROI doesn't mean what many people think it means. Let me explain.
Sure, we need to show results. But how much is enough and by when?
Yeah, that deal was a stinker. Was it worthwhile nonetheless?
You may be right. That other option was a good one. What did we miss?
The boss has made a decision. What could be the bigger picture?
ROI is a common indicator of decision making effectiveness. The follow up question must then be, "what is ROI?"
Simply stated, return on investment is the amount of money you earned on an amount of money you invested.
Seems straight forward, but (there's always a "but," and this is a big one) this definition leaves out several things that matter a great deal. Here are a few:
When money comes back, we call it a return. The return can then be compared to your expectation (goal or target or benchmark). These are cash flows that flow INTO our company.
When we put money at risk expecting a return, we call that an investment. The investment is often money, but sometimes it can be time, effort, or energy. These are cash flows that flow OUT of our company.
How long do we have to wait for the return on investment? It's good practice to clarify what time horizon we're looking at: Fiscal Year, Quarter, Month, Day, etc. Money now is generally better than money later. However, money 'later' can be estimated using today's dollars. This is the time value of money.
Nothing is without risk. So, when we put money at risk, we expect a return that matches that level of risk. So, if the risk is higher, the chance of losing money is greater, but the chance of making more money may make it worthwhile.
Money is finite. You can only put it in one investment at a time. Your investment means you can't invest in something else. This second best option is the "lost opportunity" or "opportunity cost." By comparing your investment to the second best option, you get insight into how well things turned out.
A financial ratio like ROI is only useful when you compare it to something. What was the ROI of the risk-free alternative? What did we expect? What ROI did we use to make the decision? What actually happened? What was our benchmark?
A manager may use ROI estimates as he makes a decision to invest in a piece of machinery or technology. What are the cash flows? What are the risks? What else could we have done with that money?
Think you understand? Test yourself here.
A client recently pointed out that his business unit is evaluated on ROI, but he doesn't know what the "I" is. His organization wouldn't or couldn't define for him what assets, capital, or other investments his part of the organization was accountable to. So, when his team showed a return (a profit), he had a difficult time understanding ROI. He had the "R" but no "I."
Another client pointed out that ROI is useless to her decision making. She needs a more precise ROI, like Return on Assets, Return on Average Equity, Return on Invested Capital, or Return on Cash Flow. For example, for Return on Invested Capital, she uses "EBITDA" as her "R" and then uses "Working Capital" as her "I." This gives her a more precise indicator of how well they're doing.
Finally a non-financial example: A good friend said his last meeting was a waste of time. He invested his time and got nothing for it.
There are lots of ways to evaluate ROI. I suggest you consider the following questions when you hear ROI
How much is the investment?
What OTHER options do we have with that investment? What else could be done?
When will we get our investment back? (break even)
When will we earn more than our investment? Is it enough, soon enough?
What are the risks to this investment? What can we do to assure we see the return?
By thinking more about the "R" and the "I" of ROI we can ask better questions and make better decisions. Help others understand how this indicator works and the details that go into it. There's more there than you think.