Return on Investment (ROI)

Return on Investment (ROI) analysis is one of several commonly used financial metrics for
evaluating the financial consequences of business investments, decisions, or actions. ROI
analysis compares the magnitude and timing of investment gains directly with the magnitude and
timing of investment costs. A high ROI means that investment gains compare favorably to
investment costs.

In the last few decades, ROI has become a central financial metric for asset purchase decisions
(computer systems, factory machines, or service vehicles, for example), approval and funding
decisions for projects and programs of all kinds (such as marketing programs, recruiting
programs, and training programs), and more traditional investment decisions (such as the
management of stock portfolios or the use of venture capital).

The ROI Concept and the Meaning of Return on Investment Explained With an Example
Calculating Simple ROI for Cash Flow and Investment Analysis
Comparing Competing Investments: ROI From Cash Flow Streams
ROI Compared to NPV, IRR, and Payback Period
Other ROI Metrics

The ROI Concept and the Meaning of Return on Investment

Explained With an Example
Most forms of ROI analysis compare investment returns and costs by constructing a ratio, or
percentage. In most ROI methods, an ROI ratio greater than 0.00 (or a percentage greater than
0%) means the investment returns more than its cost. When potential investments compete for
funds, and when other factors between the choices are truly equal, the investmentor action, or
business case scenariowith the higher ROI is considered the better choice, or the better
business decision.

One serious problem with using ROI as the sole basis for decision making, is that ROI by itself
says nothing about the likelihood that expected returns and costs will appear as predicted. ROI
by itself, that is, says nothing about the risk of an investment. ROI simply shows how returns
compare to costs if the action or investment brings the results hoped for. (The same is also true of
other financial metrics, such as Net Present Value, or Internal Rate of Return). For that reason, a
good business case or a good investment analysis will also measure the probabilities of different
ROI outcomes, and wise decision makers will consider both the ROI magnitude and the risks that
go with it.

Decision makers will also expect practical suggestions from the ROI analyst, on ways to improve
ROI by reducing costs, increasing gains, or accelerating gains (see the figure above).

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Calculating Simple ROI for Cash Flow and Investment

Analysis
Return on investment is frequently derived as the return (incremental gain) from an action
divided by the cost of that action. That is simple ROI, as used in business case analysis and
other forms of cash flow analysis. For example, what is the ROI for a new marketing program
that is expected to cost $500,000 over the next five years and deliver an additional $700,000 in
increased profits during the same time?

Simple ROI is the most frequently used form of ROI and the most easily understood. With
simple ROI, incremental gains from the investment are divided by investment costs.

Simple ROI works well when both the gains and the costs of an investment are easily known and
where they clearly result from the action. In complex business settings, however, it is not always
easy to match specific returns (such as increased profits) with the specific costs that bring them
(such as the costs of a marketing program), and this makes ROI less trustworthy as a guide for
decision support. Simple ROI also becomes less trustworthy as a useful metric when the cost
figures include allocated or indirect costs, which are probably not caused directly by the action or
the investment.

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Comparing Competing Investments: ROI From Cash Flow

Streams
ROI and other financial metrics that take an investment view of an action or investment compare
investment returns to investment costs. However each of the major investment metrics (ROI,
internal rate of return IRR, net present value NPV, and payback period), approaches the
comparison differently, and each carries a different message. This section illustrates ROI
calculation from a cash flow stream for two competing investments, and the next section ( ROI
vs. NPV, IRR, and Payback Period) compares the differing and sometimes conflicting messages
from different financial metrics.

Consider two five-year investments competing for funding, Investment A and Investment B.
Which is the better business decision? Analysts will look first at the net cash flow streams from
each investment. The net cash flow data and comparison graph appear below.

No Year Year Year Year Year Tota

w 1 2 3 4 5 l

Net

Cash 20 30 40 70 80 140
100
Flow A

Net

Cash 70 60 40 30 20 120
100
Flow B

Two aspects of the data are apparent at once: (1) Investment A has the greater overall net cash
flow for the five year period, but (2) the timing of cash flows in each case is quite different. The
differences in timing are even more apparent in a graphical representation of net cash flow:

To answer the question, "Which is the better business decision for the company?" the analyst will
want to examine both investments with several financial metrics, including ROI, NPV, IRR, and
Payback period.

In order to calculate ROI, the analyst needs to see both cash inflows and cash outflows for each
period (year) as well as the net cash flow. The tables below show these figures for each
investment, including also cumulative cash flow and Simple ROI for the investment at the end of
each year.

Investment A Now Year 1 Year 2 Year Year Year Tota

 3 4 5 l

Cash Inflows A 0 40 50 75 95 105 355

Cash Outflows
100 20 20 35 25 25 225
A

Net Cash Flow

100 20 30 40 70 80 140
A

Cumulative CF
100 80 50 10 60 140
A

-
Simple ROI A 30.0% 62.2%
100.0% 66.7% 35.7% 5.7%

For Investment B...

Year Year Year Year Tota

Investment B Now Year 1
2 3 4 5 l

Cash Inflows B 0 100 90 75 50 40 355

Cash Outflows
100 30 30 35 20 20 235
B

Net Cash Flow

100 70 60 40 30 20 120
B

Cumulative
100 30 30 70 100 120
CF B

-
Simple ROI B 18.8% 35.9% 46.5% 51.1%
100.0% 23.1%

Simple ROI for each investment, in each period is shown in the bottom row of each table.
Applying the cash flow ROI formula above to these data, the ROI for, say, Year 3 of Investment
B is given as
 Using simple ROI as the sole decision criterion, which investment is the better business
decision? The answer here is: that depends on the time period in view.

Considering the 3-year ROIs from each investment, clearly B's ROI of 35.9% is better
than A's ROI of 5.7%.

Considering the 5-year ROIs however, investment A clearly has the higher ROI at 62.2%,
vs. 51.1% for B's five-year ROI.

The example illustrates two important considerations to keep in mind when using ROI for
decision support:

1. For most business investments there is not a single ROI for the investment, independent
of the time period. Because business investments typically bring financial consequences
extending several years or more, the investment can have a different ROI every year (or
other period). The investment's ROI is not defined, that is, until the time period is stated.

2. The standard advice usually repeated when ROI is explained (as above) is: this: "Other
things being equal, the investment with the higher ROI is the better business decision."
However, important business decisions are rarely made on the basis of one financial
metric and with business investments, moreover, the condition "other things being equal"
almost never applies. When comparing investments with ROI, it is usually a very good
idea to consider other financial metrics as well (as illustrated in the following section).

As a final consideration in calculating ROI, note that some financial specialists prefer to derive
ROI from cash flow stream present values. In investment situations, this typically leads to a
lower ROI than the ROI from the non discounted cash flow. That is because the larger
investment costs usually come early, and the larger gains appear later, so that discounting
impacts the future gains more heavily than the future costs. In the "early costs / later gains"
situation, using discounted cash flow figures to calculate ROI leads to a more conservative, less
optimistic result. There are "pros" and "cons" to both the discounted and non discounted
approach to ROI, and the business analyst should be sure to understand which approach is
preferred by the organization's financial officers, and why.
 See the discounted cash flow entry in this encyclopedia, for a complete introduction to present
value and other time value of money concepts. For working spreadsheet examples of the
calculations in this and the following section, see Financial Metrics Pro.

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ROI compared to NPV, IRR, and Payback Period

The different natures of investments A and B are also apparent in a line graph of the cumulative
cash flow for each (cumulative cash flow for a period is the sum of all net cash flows through the
end of the current period). This is the fourth data row in each table above. Cumulative cash flow
and payback are explained more fully in the encyclopedia entry for payback period). In fact,
some people call a cumulative cash flow graph, such as this one, a return on investment curve.

Which investment, A or B, is the better business decision? In this section, you should see that
each investment has points in its favor, compared to the other, and that ultimately decision
makers will have to weigh ROI results along with several other metrics, to decide which is best
for their organization at the present time. Here are some of the points to consider:

ROI: Investment A has the higher 5-year ROI (62.2% for A vs. 51.1% for B). That is a
point in A's favorif the time period in view is 5 years.

Future Performance: The cumulative curves above only cover 5 years, but if the
investments inflows and outflows are expected to continue beyond 5 years, the curves
point to two different futures. By Year 5, A's cumulative cash flow curve is heading
skyward, while B's appears to be leveling off. If there is reason to believe these patterns
will continue, this is also a point in favor of A.

Payback Period. The cumulative cash flow curves above show roughly the point in time
when the cumulative cash flow "breaks even," that is, when cumulative incoming returns
exactly balance cumulative outflows. This point in time (point on the horizontal axis) is
Payback period for each investment (see payback period). The payback period for B is
 1.5 years, while A's payback period is 3.14 years. Investment B "pays for itself" in half
the time of investment A. The shorter payback period is preferred because it means
invested funds are recovered sooner, and available for use again sooner. The shorter
payback period is also viewed as less risky than the longer payback. These are points in
favor of investment B.

Net present value (NPV): Using a 10% Discount rate, Investment B has a net present
value (NPV) of 76.18, while A's NPV is 70.51. With the time value of money rationale,
this means that investment B is worth more, today, than investment A, even though A will
ultimately (in 5 years) return more funds. This is a point in favor of B.

Internal rate of return (IRR): Internal rate of return (IRR) is the interest rate that
produces an NPV of 0 for a cash flow stream (see Internal rate of return for a complete
overview of what this means and why it can be important). Investment A has an IRR of
28.9% while B's IRR is 44.9%. Roughly speaking, financial officers will view a potential
investment with an IRR above their cost of borrowing as a net gain. When investments
are competing for funds, of course, the higher IRR is preferred. This is a point in favor of
investment B.

Based on the financial metrics reviewed above, which investment, A or B, is the better business
decision? Clearly there is no "one size fits all" answer, except to say that ROI is one factor
decision makers and planners will consider, but they will consider other factors as well and give
different "weights" to the different financial metrics above, based on (a) the company's business
objectives, and (b) the current situation.

For more on prioritizing business objectives and connecting them to financial metrics, see The
Business Case Guide or Business Case Essentials.

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Other ROI Metrics

Other financial metrics are also treated as ROI figures at times.

In financial statement analysiswhere analysts assess the financial health and business
performance of companiesReturn on Invested Capital, Return on Capital Employed,
Return on Total Assets, Return on Equity, and Return on Net Worth, are sometimes called
return on investment.

In still other cases, where the focus is cash flow analysis, the term ROI has been used to refer
simply to the cumulative cash flow results of an investment over time, such as shown in the
preceding section. Some people also refer to other financial metrics as "ROI," such as "Average
Rate of Return" or even Internal Rate of Return (IRR).
In brief, several different return on investment metrics are in common use and the term itself
does not have a single, universally understood definition. Therefore, when reviewing ROI
figures, or when asked to produce one, it is a good idea to be sure that everyone involved:

Defines return on investment the same way

Understands the limits of the concept when used to support business decisions

For more practical guidance on building a business case and other financial metrics, see Business
Case Essentials or the Business Case Guide, or the spreadsheet-based teaching tool, Financial
Metrics Pro