by Malcolm Simister
The acronym ROI is bandied about a lot, sometimes even in non-financial contexts, but I find it’s often only vaguely understood. As ROI is perhaps the single most important financial measure, it’s worth understanding it.
In French, Roi means ‘King’ and in Finance ROI, just like cash, is King too. It’s the King of financial ratios and is EBIT as a percentage of the total Capital Employed in the business. Put another way, it’s the Profit generated by the Operating Business compared with the Capital used by the Operating Business, both Equity and Debt. It reveals whether the guts of the company is doing well, financially. Let me explain.
EBIT (Earnings Before Interest & Tax) is the profit of the Operating business that resides inside a company. The Operating business comprises selling what the business produces and the activities to support that such as marketing, IT and general administration. It excludes the costs of financing the business and tax on profit.
EBIT is a crucial number because the financial success of the company ultimately depends on it. If EBIT is bad, it means that the operations aren’t doing well and, ultimately, the company won’t be successful financially.
Naturally, other things equal, the bigger the company, the bigger you’d expect EBIT to be. But it can be that a big company with a big EBIT isn’t actually doing as well relatively as a smaller company with a smaller EBIT.
This is because a company uses Capital whose providers want a return. Companies raise Equity from shareholders (who want dividends and an increase in the value of their shares) and Debt from banks or elsewhere (who want interest and, ultimately, repayment of the debt). Equity plus Debt is total Capital Employed.
So, comparing the Profit of the Operating Business, EBIT, with Capital used by that business, Capital Employed, reveals how well the company is using the Capital and, therefore, how good the returns to the shareholders and banks are.
While differences in EBIT for similar businesses of different sizes doesn’t reveal how well they are performing, comparing their ROIs does. Other ratios and measures matter too – one is not enough – but if I had to choose only one financial number to look at, I’d go for ROI, the King of financial ratios.