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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).
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.
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.
Now

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Net Cash Flow A 100 20 30

Net Cash Flow B 100

70 60

40
40

70 80 140
30 20 120

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 3 Year 4 Year 5 Total
Cash Inflows A

Cash Outflows A

100

Net Cash Flow A

100

20

Cumulative CF A

100

80

Simple ROI A

-100.0%

40

50

75

20

95

20
30
50

35
40

105

25
70

10

60

25
80

355
225
140

140

66.7% 35.7% 5.7% 30.0% 62.2%

For Investment B...

Investment B Now Year 1 Year 2 Year 3 Year 4 Year 5 Total
Cash Inflows B

Cash Outflows B

100

Net Cash Flow B

100

70

60

40

30

Cumulative CF B

100

30

30

70

100

Simple ROI B

-100.0%

100
30

90

75
30

50
35

23.1% 18.8%

20

40
20

355
235

20 120
120

35.9% 46.5% 51.1%

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.
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.
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

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