One of the most effective tools for financial business evaluations whenever the company wants to evaluate the manager or the segment departments is to use the ROI ( Return on Investment ), and/or using RI ( Residual income).
I would like to explain what are these two tools that the companies can use and what are the difference between them.
In the beginning, allow me to introduce to you what is the ROI means It is one of the financial ratios used to determine the profitability of the company means it is a percentage, not a dollar amount and there are many ways to compute it.
But in this article, I will choose one way to find it based on the below formula:
Net income/ Total assets.
For example, if the company has a net income of $100,000 and $1,000,000 in assets. ROI = 100,000/ 1,000,000 10% And if this percentage get increased it might be a good sign for investment.
Second things the RI.
This is based on currency amount and has a different way to calculate rather than the ROI.
The companies have to use the below formula: Net income _ The cost of the capital. and here I am going to explain what is mean the cost of the capital. It is obvious that the company has assets which it has been used to generate profits, and these assets have been obtaining from 2 sources one is the owner's equity and the second is the debit finance.
And both have costs such as the divided to the owners and the debit interest. So both are called WACC ( weigh the average cost of the capital ).
Let me explain this part by implementing an example. Same as the previous numbers the net income was $100,000 and the assets $1,000,000.
Also, the cost of the capital is 6% it has been computed based on certain functions that I will take about it later in another article. But let us consents to find the RI now So the RI based on the above formula 1,000,000 × % = 60,000 100,000 _ 60,000 = 40,000 This means the company has covered the cost of the capital and the remaining $40,000 belongs to the company.
Finally, I would like to add about the advantages and disadvantages of using both methods.
ROI
Advantages:
• It is probably easy to use and understand by management.
• it can be used to compare different sizes of segments.
Disadvantages:
• It is a represent of misleading knowledge, and therefore to wrong decisions, where mangers may refuse to accept a new investment if the ROI is getting lower even if the RI still has a positive impact.
RI
Advantages:
• It is better to use than the ROI since it gives the management a full view of the real returns of the investment.
Disadvantages:
• Can not be used to compare different sizes of segments.
In the end, I would like to show you that both methods have limitations where both ways are using numbers from the income statement and the balance sheet, and both statements have it is own limitations like the way the assets have been depreciated or how the net income computed.
So to make the best comparison between the different segments we have to make the net income and balance sheet computation the same at all times.
Comments