How to Define Investment to Measure the Investment-Related Profitability Ratio?

What is Return on Investment?

The profitability ratio related to investment is Return on Investment (ROI). Return on Investment is the ratio that is sometimes expressed as Profit After Tax (PAT) divided by Investment. The investment represents the pool of funds accumulated by components invested by shareholders and lenders.

So, the most common assumption of ROI is given as follows −

$$\mathrm{ROI\, =\, \frac{PAT}{Investment}}$$

However, it is incorrect to use PAT in measuring returns on Income because PAT is the residue income of shareholders. It is not the overall amount of funds invested by the lenders and general shareholders.

Also, PAT is affected by a company’s capital structure and in the calculation of ROI, it can be used in two forms.

So, ROI ratio can be represented in the following two forms −

$$\mathrm{Return\, on \, Total\, Assets\, =\, ROTA \, =\, \frac{EBIT \, (1-T)}{Total\, Assets}}$$

and

$$\mathrm{Return\, on \, Net\, Assets\, =\, RONA \, =\, \frac{EBIT \, (1-T)}{Total\, Assets}}$$

As taxes are not controllable by the management of a company and because the availability of tax incentives differs from company to company, the before tax ratios mentioned above can be represented as −

$$\mathrm{ROI\, =\, ROTA \, =\, \frac{EBIT}{TA}}$$

$$\mathrm{ROI\, =\, RONA \, =\, \frac{RBIT}{NA}}$$

So, investment takes the forms of Total Assets (TA) and Net Assets (NA) in the calculation of the Investment-Related Profitability Ratio.

Thus, the above representations imply that –

• ROTA Includes All Forms of Funds

The investment in the calculation of Return on Total Assets is the investment that included all forms of funds that have been invested in a project. Total assets include assets that may have or generate something that increases the value of the company. The total asset value may or may not include the assets' current market prices.

• Conversion of Assets

Moreover, owners of assets may consider their assets valuable depending on the time required to convert the assets into cash. This property of converting assets into cash is known as liquidity.

• Nature of Liquidity

Assets on the balance sheet of a company are recorded as current assets or long-term assets depending on their nature of liquidity. Current assets include marketable securities, accounts receivable, etc. while long-term assets include fixed assets that can be liquidated within a time period of more than one year.

The measurement of the value of assets is particularly of interest to an acquirer. Depending on the value of assets, an acquirer may calculate the value of the company. If the acquirer finds that the value of the company is more than the value of assets, he may reduce the bid price. In case the bid price is lower than the value of the assets, a revision to a higher one may be expected.

• NA as Investment

Net assets can be considered as the investment in the case RONA is taken as the ROI. The net asset is the form of assets that comprise a company’s assets minus its liabilities.

It is given as follows −

$$\mathrm{(Fixed\: Assets\, +\, Current\: Assets)\, -\, (Current\: Liabilities\, +\, Long\: Term\: Liabilities)}$$

Net assets can be considered as a form of investment. However, for that to do, we must deduct all liabilities from the total assets.

Conclusion

Two points can be concluded from this article; they are as follows −

• Total assets can be a measure of investment in calculating the ROTA. However, it must be noted that to calculate ROTA, the current market prices of assets may or may not be considered. It is usually better to consider the market prices of assets though.

• Net assets can be considered to be a better measure of a company’s investment scenario as it deducts the value of liabilities from the total assets. It is important to look at the assets that may provide value to a company and so deduction of the value of liabilities is handier than the acceptance of total assets as the investment.