Return on investment (ROI) is a term used to describe the gains emanating from a venture. An elevated ROI indicates that the benefits from the venture are positively compared to the outlay. Being a measure of performance, ROI is employed in the evaluation of the effectiveness of a venture or assessment of the success of numerous dissimilar ventures. In simple economic terms, it is a means of mulling over profits with respect to the vested capital (Knight par. 1-3). In the calculation of ROI, the gain (return) from a venture is divided by the outlay and the outcome is expressed as a proportion or percentage.
Description of the Analysis
Prior to making an investment, one should compute the ROI through the comparison of the anticipated gains with the outlays. However, the calculation of the ROI is not as easy as it appears, and mistakes that a number of managers make lies in the confusion of profit and cash. There is a significant difference between the two, since (if profit is mistaken for cash in the computation of ROI) a firm can demonstrate an extremely better return than could be attained. Profits appear in the income statement of a firm illustrating what remains when every cost and outlay is deducted from the revenues of the firm. Nonetheless, this is not directly linked to cash. As Knight (2015) ascertains, revenue is not a cash-anchored figure as a firm could record revenue every time it is transporting products or offering services to its clients, whether the clients clear the bills or not (par. 1-5). On the other hand, cash deals appear on the cash flow statements where the statements show that cash is made through the firm’s transactions, money used in the transactions, money used for capital assets, and money obtained from, or issued to, lenders as well as investors.
Report on the Findings
In business, the significance of the ROI depends on the amount of returns on investment of an economic entity in a given time. The most common mistake in the evaluation of ROI can be made when comparing the initial venture with returns, which is at all times done in cash. The right approach is to employ cash flow, the real quantity of cash going in and out of a firm, for a given time. For instance, a firm could desire to know whether to embark on a new ten million dollars investment, which would allow it to obtain ten million dollars in revenue and three million dollars in profits every year (Knight par. 6-8).
Pleasing would appear in the form of returns, when the firm commences its operations, two million dollars could be required for inventory and the accounts receivable. What the clients owe to the firm for services offered or products issued, could be increased by one million dollars. The two variables alone could take up all the three million dollars in profits thus the cash flow could be zero dollars (Knight par. 9-17). There is a need to consider the time value of money and approximate returns anchored in the cash flow as compared to earnings. In this regard, the directors of a firm have to be conscious of the stumbling blocks and work out the best way of ROI calculation.
Works Cited
Knight, Joe. “The most common mistake people make in calculating ROI.” Harvard Business Review, 2015. Web.