Comparative Discussion Between ROI & RI

Return on investment (ROI) is defined as net operating income divided by average operating
assets.

ROI = Net Operating Income ÷ Average Operating Assets

= (Net Operating Income/Sales) ÷ (Sales/Average Operating Assets)

= Margin × Turnover

Income could be one of the following: operating income or EBIT (earnings before interest and
taxes), net income, or net cash inflows. Investment could be: total assets, working capital,
stockholders' equity, or initial cash outlay. Typically, average amount for the period is used.

It is calculated in percentage. Return on investment is a common but classic tool in performance

evaluation. Companies use ROI as a method to measure the rate of return of a company’s capital
investments. The higher the return on investment, the better. Again, margin and turnover are
important concept in understanding how a manager can affect ROI, e.g.- excessive turnover can
depress turnover and lower ROI. The management may use benchmarks in evaluating the ROI.
For example, say in a particular industry, the average ROI is 20%. If the subunit's ROI is 8%,
then that is not even half of the acceptable rate. The management may decide on how to improve
the subunit's ROI or drop it and invest in more profitable ventures

Residual income (RI) is another approach to measure any investment’s performance evaluation.
Residual income measures the net income an investment earns beyond the lowest return on its
operational assets.

Residual Income = Net Operating Income – (Average Operating Assets × Minimum Required
Rate of Return)
Residual income valuation is a process of business equity evaluation that accurately calculates
the cost of equity capital. The primary application of this method is to calculate a rate of return
that provides investors and managers a means to measure the compensation for their opportunity
cost. Even if a project shows a profit, the residual income valuation may show that this specific
project may not have been as profitable as another opportunity.

The residual income is more effective and more used by the managers in evaluating investments.
If the companies only use ROI, they would divest the subunits except one which has the highest
ROI. RI is better tool. It offers more opportunities. Managers who are evaluated based on the
residual income method will make better decisions about investments than managers who are
evaluated based on the ROI method.