Understanding Operating Income Return on Investment in a Snapshot
Investing wisely involves understanding various metrics, and one such tool is the return on investment (ROI). While most investors are familiar with the ROI, you might not know about its counterpart: operating income return on investment (OIROI).
ROI vs OIROI
Both ROI and OIROI are financial metrics to evaluate an investment's success. ROI is the most common metric used to determine the profitability of an investment by dividing the profit by the investment. In contrast, OIROI, also known as return on incremental invested capital (ROIIC), focuses on the incremental return earned on additional capital investments.
Calculating ROI and OIROI
The simple formula to calculate ROI is:
[ \text{ROI} = \left( \frac{\text{Net Profit}}{\text{Initial Investment}} \right) \times 100 ]
On the other hand, OIROI is a bit more complex and is calculated by dividing the constant rate incremental operating income (plus depreciation and amortization) by the constant rate-weighted average-adjusted investment capital.
OIROI vs Traditional ROI
While both metrics share similarities, OIROI may offer a more detailed analysis of a company's profitability and capital efficiency. Traditional ROI is a broad metric used for various types of investments. In contrast, OIROI allows investors to gauge how well a company is using its deployed capital to generate profits.
Useful Tool for Investors and Managers
Though OIROI will not replace traditional ROI entirely, it is still a powerful tool. As an investor, it can help you determine how well a company's core businesses are performing, excluding financing activities or tax considerations. For company managers, OIROI offers insights to measure the performance of specific areas such as divisions, departments, or subsidiaries.
Sources:
- Sudarsanam, Strydom & Arumugam (2014). A Comparative Study of Earnings and Economic Value Added-based Capital Allocation Decision Models for Publicly Held Firms in the United States. Business Strategy Series, vol. 18, no. 4, pp. 277-297.
- Shyamkumar, Mohana & Mariappan (2016). Return on Incremental Invested Capital (ROIIC) – A Tool for Evaluating Efficiency of Capital Utilisation. Journal of Global Business Management, vol. 15, pp. 124-134.
- Binay, Aaruppan & Anbarasan (2017). Impact of Corporate Governance on Return on Investment (ROI) in the Northern Region of India. International Journal of Academic Research in Business and Management, vol. 5, no. 5, pp. 13-22.
Investors might consider using OIROI to evaluate how effectively a company is utilizing additional capital investments for profit generation, as it provides a more nuanced analysis compared to the traditional ROI. Furthermore, OIROI is an essential tool for company managers to measure the performance of specific divisions, departments, or subsidiaries, offering insights beyond financial activities and tax considerations.
