Financial Metrics Overview:  Return Metrics

Audio Version (SPaMCAST 139)

The Metrics Minute begins an exploration of financial metrics.  The first class of financial metrics is those metrics that are used to decide which projects should be done.  I call these return metrics and they ask the questions: Should we do this project? And more broadly, are their better uses for our assets? Generally these questions are asked at the beginning of a project but can be equally powerful at different times during the project life cycle. Return metrics are focused on the financial aspect of the project, but less tangible assets can be incorporated.  Attributes such as risk and strategy are examples of attributes that are often quantified and incorporated.

Examples of this class of metric include Return on Assets (ROA), Return on Investment (ROI), payback period and Internal Rate of Return (IRR). In all cases these metrics account for income, a hurdle rate (interest rate or expected rate of return) and a comparison cost, based either on assets, income, or equity. While these ratios are a rich source of decision making information, they are not tools with which to manage a project or programs.

Metrics Minute: Return on Assets (ROA)
Thomas M. Cagley Jr.

Definition

Return on Assets (ROA) is a ratio of the earnings generated from a project compared to the assets used to generate that revenue. ROA is a classic financial metric that when applied to projects, is typically used as a technique for project acceptance or, in retrospect, as a tool to evaluate overall performance.

Formula

ROA = (Estimated Net Income + Estimated Interest Expense) ÷ (Average Assets during the period)

Estimated Net Income is the residual income that results from a project after adding total revenue and subtracting all expenses for the project for a specific period of time.

Estimated Interest Expense is any interest expense related to the project so that the costs associated with funding those assets is ignored by adding the interest expense back into net income.

Average Assets represent either the statistical average or mode of the asset valuation for those assets involved in generating the project’s income.  An average is used to at least partially negate the value variance across the period of time being studied (for example, a year).

Usage

The primary use of ROA is to compare a potential project to other possible projects in order to determine which makes the most sense to pursue.  Projects with a higher ROA are more likely to be included in the portfolio of projects.

An alternative use of ROA is as a tool to evaluate projects or a portfolio of completed projects.  In this case the metric can be periodically recalculated using completed projects to determine whether an overall project portfolio represents an efficient use of assets or if segments of the portfolio offer high a higher return on assets.

Issues

There are several issues with the calculation and use of ROA as a decision tool.  Most of these center either on making apples-to-apples comparisons or using the metric without regard to other factors.  The most significant issues are:

Return on assets is not useful for comparisons between projects in different industries or product segments because the factors of scale and peculiar capital requirements can be different. Stratifying groups of project into so that an apples-to-apples comparison can be made is one method that can be used to ensure an apples-to-apples comparison. Similar methods to ensure good comparisons are required when organizational goals require a spread of projects across a diverse product portfolio that has differing return profiles.

A second issue is that intangible assets may affect the rational for project selection which forces organizations to address valuation of intangible assets. This issue is a relative of the “numbers don’t tell the whole story” argument. Valuation of intangible assets requires a judgment call and unless that judgment is based on rules or guidelines those judgment calls will be open to question or manipulation.

Related Metrics

• Return on Equity (ROE)
• Return on Investment (ROI)
• Payback Period
• Internal Rate of Return (IRR)
• Net Present Value
• Total cost of ownership

Criticisms

Criticisms of ROA, like the issues noted earlier, revolve around how metric is used.

This first criticism is comparisons across companies and industries are difficult due differing asset structures that are not very easy to discern.  Asset structures may differ between product lines within the same company which makes comparisons difficult. This criticism is true; however, unless there is an organizational imperative for project and product diversity, the organization should be maximizing return on assets to ensure it is meeting its fiduciary responsibility.

A second criticism:  While most users of the ROA metric would agree that other factors are important to consider, most organizations have not determined a set of standard factors to consider. For example, risk or risk weighting of the ROA results can provide a richer decision-making tool; however, there isn’t general agreement on when and how to use this additional factor.   This criticism is the most troublesome. I would suggest not using a one-size-fits-all set of factors or discount rate; rather I would discount the net income based on a risk adjusted discount rate. The higher the risk, the higher the discount rate would be set. A formal approach to measuring or estimating risk will be required to avoid manipulation of the analysis. Other financial ratios or metrics are useful in expanding the factors being weighed when comparing potential projects (or performance). As an example, ROI (return on investment) may present a different perspective if cash outflow needs to be more highly weighted. In some scenarios specific assets other than cash may be underutilized; therefore, a lower hurdle rate might be in order (or liquidation of the assets) to ensure more intensive use of the asset class.

A third criticism of ROA centers on the valuation of the Total Assets when it reflects a snapshot of a particular moment in time. The idea is that asset valuation can and does vary, and that variance could change how any specific project is evaluated.  To deal with the issue I suggest periodic revaluations of the portfolio to ensure that the business environment does not change enough to effect the composition of the project portfolio.  Note the needed to re-evaluate projects is need more often for projects that are on the line between acceptance and rejection.