Advantages of Return on Investment:
ROI has the following advantages
(i) It relates net income to investments made in a division giving a better measure of divisional Profitability.
(ii) It can be used as a basis for other ratios which are useful for analytical purposes.
(iii) It is easy to understand as it is based on financial accounting measurements.
(iv) It may be used for inter firm comparisons, provided that the firms whose results are being compared are comparable size and the same industry.
Disadvantages of Return on Investment:
ROI has the following limitations:
(i) Satisfactory definition of profit and investment are difficult to find. Profit has many concepts such as profit before interest and tax, profit after interest and tax, controllable profit, profit after deducting all allocated fixed costs. Similarly, the term investment may have many connotations such as gross book value, net book value, historical cost of assets, and current cost of assets, assets including or excluding intangible assets.
(ii) While comparing ROI of different companies it is necessary that the companies use similar accounting policies and methods in respect of valuation of stocks, valuation of fixed assets, apportionment of overheads, treatment of research and development expenditure etc.
(iii) ROI may influence a divisional manager to select only investments with high rates of return (i.e. rates which are in line or above his target ROI). Other investments that would reduce the division‘s ROI but could increase the value of the business may be rejected by the divisional manager. It is likely that another division may invest the available funds in a project that might improve its existing ROI (which may be lower than a division‘s ROI which has rejected the investment) but which will not contribute as much to the enterprise as a whole. These types of decisions are sub-optimal and
can distort an enterprise‘s overall allocation of resources and can motivate a
manager to make under investing in order to preserve its existing ROI.
ROI has the following advantages
(i) It relates net income to investments made in a division giving a better measure of divisional Profitability.
(ii) It can be used as a basis for other ratios which are useful for analytical purposes.
(iii) It is easy to understand as it is based on financial accounting measurements.
(iv) It may be used for inter firm comparisons, provided that the firms whose results are being compared are comparable size and the same industry.
Disadvantages of Return on Investment:
ROI has the following limitations:
(i) Satisfactory definition of profit and investment are difficult to find. Profit has many concepts such as profit before interest and tax, profit after interest and tax, controllable profit, profit after deducting all allocated fixed costs. Similarly, the term investment may have many connotations such as gross book value, net book value, historical cost of assets, and current cost of assets, assets including or excluding intangible assets.
(ii) While comparing ROI of different companies it is necessary that the companies use similar accounting policies and methods in respect of valuation of stocks, valuation of fixed assets, apportionment of overheads, treatment of research and development expenditure etc.
(iii) ROI may influence a divisional manager to select only investments with high rates of return (i.e. rates which are in line or above his target ROI). Other investments that would reduce the division‘s ROI but could increase the value of the business may be rejected by the divisional manager. It is likely that another division may invest the available funds in a project that might improve its existing ROI (which may be lower than a division‘s ROI which has rejected the investment) but which will not contribute as much to the enterprise as a whole. These types of decisions are sub-optimal and
can distort an enterprise‘s overall allocation of resources and can motivate a
manager to make under investing in order to preserve its existing ROI.
No comments:
Post a Comment