Profitability Ratios and the Importance of ROI Essay

Profitability Ratios

I have never seen the payback method used in practice, having worked for trained financial professionals during my time working in government. I can, however, imagine some small businesses using this method. A good example I have seen in my travels might be a shopkeeper in the developing world. Such businesses usually do not have access to credit, so payback period is more relevant to their needs, as they must carefully manage their cash flow. For businesses that have access to credit facilities or equity financing, there is little need to manage cash flow so tightly that payback period would be the optimal method of making capital spending decisions.

Similarly, the internal rate of return method is seldom-used by serious financial professionals. This method focuses on the rate of return that the project generates. In some situations, there is an incentive to utilize this method in a company or unit where emphasis is placed on increasing ROI above all else. I work in government, and ROI is sometimes used to make project decisions. There are two reasons for this. One is that funding scarcity is sometimes not an issue, which means that the focus can be placed strictly on ROI, rather than deciding between mutually exclusive decisions. Under that circumstance, the project that has the best returns, regardless of size, is sometimes the one that is chosen.That said, focusing on IRR is a poor methodology because for just about any organization, funds are scarce. Even governments do not typically enjoy carte blanche to spend, and must make decisions in an environment of scarcity.

Al-Raise and Al-Koura (2010), in writing about the use of ROI in government projects in the UAE, albeit a completely different governmental environment from those in the West, note that ROI is often used as an assessment tool, after the investment has been made. They make the point that ROI has value in determining the value of projects once the project is underway, something that can affect the decision to take the project forward, and can be added to the body of knowledge that managers have to help evaluate projects of a similar nature in the future.

Net present value reflects value added, and using NPV reflects a decision on the part of management to increase the value of the organization. This is not always used in government, because government often seeks non-financial outcomes with its projects. NPV, IRR and payback are strictly financial. As a general rule, however, NPV is the best method of….....