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I am pleased to let everyone know that I have been asked to speak at the Financial Planning, Forecasting and Reporting Summit this October 16-17 in Boston, MA. Please come and introduce yourself at the event. I look forward to seeing everyone there. For more information, go to www.finance-summits.com.
Scott
1 Comment
 This term is used often and often overused with no supporting analysis. The term is thrown around to justify spending for new positions, projects, systems and other projects. People use the term to justify increased in spending to cover regulatory and compliance items (as examples) with no increase in future cash flow. They are still required and need to be done, but they are not “investments” with a financial return. People also often introduce accounting methods to justify the ROI. Since the contract will be amortized or depreciated over three years they assume the investment is spread over three year. While that may be the correct accounting, the cash was spent up front and the cash flow must be used to calculate the ROI.
Now, let's take a look at what ROI is and how it is calculated. Then, it will be clearer how the term is misused. To be redundant, the key to determining ROI is all about cash flow. When analyzing an investment there are three key consideration: 1) how much and when cash will be spent (the investment) and 2) how much cash and when it will be received and 3) how much risk does the investment carry. The timing of the cash flows, bot in and out, are just as important as the amount of cash. The best way to explain why is to use a simple example. You put $100,000 in a bank account and in a year you get $103,320. The bank is 100% insured and therefore has zero risk. We have all three requirements to analyze the investment. 1) The cash will spent on day one 2) the cash will be received on day 365 and 3) there is zero risk. Another example is buying a new piece of machinery that cost $100,000. It will allow work that was previously done by an outside vendor to be done inhouse without adding any addition employees. There is high demand for the product produced by the machine and it will cost $2,000 per month to operate the machine. But, they will stop paying $11,382 per month to the outside vendor. Which is a better investment? How can we compare a bank investment versus a capital investment? Is this apples and oranges? At first glance the situations look so different. Actually, they are analyzed the same way. At the end of the year: · Both investments return $3,200 in cash above the original investment · Both investments also have the original money invested (we will ignore depreciation to keep it simple) If both investments are worth the same at the end they must have the same ROI, right? Well no, the ROI is different. The bank investment is 2.9% versus 5.2% for the capital investment. This is due to when the cash is received. Since the production costs are avoided starting in the first month the cash flow becomes positive before the bank returns our principle and interest. Deciding between the two investments is not a decision if the additional return of 2.3% (5.2% less 2.9%) is worth the additional risk. This is not a mathematical question, but a question of management judgment. How confident are we about the demand for the machine? How confident of our ability to operate the machine? These are just two of the questions that address the risk of the capital investment. The bank investment is 100% insured and therefore carries no risk. Notice the accounting of the investments is not mentioned as a factor on the ROI. Cash Flow is the determining factor of ROI. |
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