Return on investment is income from operations or some other measure of return divided by
(1) total operating assets,
(2) total operating assets less current liabilities, or
(3) net operating assets.
Return on Investment (Total Assets) = Assets Total Sales×Sales Return = Assets) Total ( Investment on ROI = EBIT ( Earning before interest and taxes ) Capital employed× 1
Strengths:
• The amount of return is related to the investment base required to generate that return. Thus, the emphasis is on the rational allocation of scarce capital resources.
• ROA normalizes the size effect since it is a ratio. Thus, we can compare entities of different sizes.
• As a percentage-return measure, ROA is comparable to cost-of-capital and market rate of return measures.
• Changes in ROA will lead to changes in EPS. Thus, achieving ROA objectives consistent with an f firm’s cost of capital will lead to the achievement of desirable levels of total earnings, EPS and corporate ROA.
Weaknesses:
• There is no incentive for a division to expand to the point where the marginal return on investment equals the cost of capital.
• ROA can be improved by selling low-return but acceptable projects.
• As an accounting measure, ROA has all of the defects of such measures.
The reasons for the use of ROI as a measure of performance are:
• Provides an incentive to unit managers to balance profit and investments.
• Guides corporate management in making more capital available to units in the organization that are the most effective.
• Provides corporate management a base for measuring relative profitability of different units irrespective of size.
Note: ROI may be used as a measure of performance but it is not advisable to use it as a measure of decision making on investment. Sometimes using ROl as a measure may tend to limit growth. Suppose the corporate directors require a 15% ROI for the group, whilst an investment center or strategic business unit (SBU) currently earn an 18 % return. In this case, the SBU management is unlikely to undertake investment which will reduce their ROI to, say 14.5%. But the directors with a view to the corporate goal might prefer a return of 14.5% for the SBU rather than the existing size and ROI of 18%. The manager of an SBU will care more for short-term profit than for profit in the future. He may neglect R&D and other aspects like staff development and advertising in order to show more cash flow and profit through his accounts and thereby raise his ROI, as’ his object is to get a promotion to the Board of Directors. He cares little for the long term growth of the company. Goods and services should normally be transferred between SBUs at a fair price but if for taxation or other purposes the price fixed is low, the SBU transferring the goods or services may find the price de-motivating.