If your company is in the process of undergoing a merger or potential investment from an outside source, you may find yourself inundated with report requests from accounting asking you to justify your IT expenditures. For the chief technology officer who’s been more interested in developing networks and e-commerce strategies than spreadsheets, the demand for return on investment figures can not only be frustrating but also confusing.
While it may just sound like accounting jargon, there are some very good reasons why the ROI component indicates a company’s financial health.
Importance of ROI
A CIO needs to evaluate an ROI because the essence of an enterprise’s business underpinnings lies in answering the question of return on investment. Investors want to know how much the business projects to earn in three to five years.
Most venture capitalists use these forecasts to target their own ROI. A target ROI of 60 percent compounded per annum over a three-to-five year period is the norm. For Internet dot companies, the target is closer to 70 to 90 percent because of the perceived risk. In today’s market, none of the formulas seem to take into account the losses and projected losses forecast over a three-to-five year period that only propel the companies into higher-yield IPOs and soaring stock valuation.
Investors convert the ROI percentage to four or five turns on their money in three years, or approximately 10 turns on their money in five years. A “turn” is the realization of a 100 percent gain on the money invested. So one turn, to use a common expression, is double your money back. The basic assumption is that the company will achieve a public market for its common stock within three to five years or sell out for cash or stock, thus producing the return.
These desired rates of return may strike you as overly ambitious and unrealistic, but they aren’t. Some of the foremost private venture capital firms achieve such ROIs in six investments out of 10.
Do you spend half your time making a budget, only to readjust it again a month later? Can you make sense out of the spreadsheets your accounting department constantly sends you? What’s the best way to calculate ROI or TCO? If you have an accounting conundrum that you’d like answered or explained, send your question to Ask Jack . Every month, Jack Fox will answer questions from savvy CIOs who just don’t have time to become experts in bean counting.
Investors first analyze the three-to-five-year operating statement projections. They look at the third year’s projected earnings and multiply by an appropriate price/earnings ratio for similar companies, say 10.0 to 12.0 times. The investors then multiply the amount they are being asked to invest by 4 or 5 and divide the resulting number by the first sum to determine the required percentage of ownership they must invest in order to realize their profit goals. If the percentage of ownership is too high, then the deal lacks the desired potential return and will be rejected. On the other hand, if the ownership requirement level is too low, they will ask if there is pricing flexibility and a willingness to negotiate before they go forward.
What is ROI?
ROI relates after-tax earnings to the corporation’s total asset base and is sometimes referred to as return on assets (ROA) or return on total assets (ROTA). All three expressions—ROI, ROA, and ROTA—generally have the same meaning.
A common alternative computation of this ratio adds the after-tax cost of interest expense to the numerator, on the theory that return on investment should consider the return to creditors as well as to stockholders. Using earnings after tax plus interest expense as the numerator in the equation measures the return to both the creditors and stockholders.
Reality-based crystal ball gazing
Your articulation of the plans for achieving the forecasted sales objectives must be well thought out and carefully expressed. Avoid the classic error made time and again by overanxious CIOs—developing projections for sales without being in a position to deliver. Production capability must be calculated to be in place when the marketplace responds to the company’s products or services offerings.
Ultimately, it is the credibility of the CIO, CFO, and the remainder of the key management team, in concert with the facts they are presenting, that makes the projections believable.
Key interrelationships among ratios
The CIO cannot consider any individual ratio in isolation. It is important to consider the interrelationships among the various ratios. Your firm’s profitability, liquidity position, operating efficiency, and leverage position are all interrelated, and no single aspect of performance should be considered apart from other aspects. There is, however, a caveat: The compilation and display of a set of ratios for your company in a given year is of limited usefulness by itself. Ratios must be compared to performance in other years and to appropriate standards for companies of approximately equal asset size in similar industries.
Internet references for further information
- AccountantsWorld.com (www.accountantsworld.com )
- Faulkner & Gray’s electronic accountant (www.electronicaccountant.com )
- Money Tree Software (www.moneytree.com )
- CPAinfo.com (www.cpainfo.com )
- Pro2Net Accounting (www.accounting.pro2net.com )
Jack Fox is the executive director of The Accounting Guild in Las Vegas, NV. Fox has been assisting thousands of accountants and IT consultants in building their own successful businesses. He has also been coaching for effective leadership in IT functions of small- to medium-size enterprises since 1984. He is the author of five books, including the third edition of Starting and Building Your Own Accounting Business, published by John Wiley & Sons.