business-modelOk, there is a company A in a country A selling electronic equipment. Generally, they import the electronic equipment from oversea and sell them in country A. Within 1 year time, company A achieved 8400 million in revenue and 352 million in profit. So the ROI is 4.2% / year.
In the country A, the interest rate is 5%. So the company A could get more $$ without doing anything by just putting its money into the bank. Specifically, company A could get 420 million interest (5% * 8400) a year.
But that company still does not withdraw itself from the market.
So, Why do companies still want to invest into retailing business even its ROI is lower than the bank interest rate?
First off, I imagine you arrived at 4.2% by computing profit / sales. But that’s not an ROI.
To calculate an ROI, you’d do:
ROI = Return on *Investment*
= net profit / investment
But then, don’t be tempted to compute 352 / (8400 - 352) either. It won’t tell you anything useful, because the company doesn’t need $8Bn in the bank all year round to generate these $352M of profits.
For all you know, it could be paying suppliers 60 days upon receipt, shipping to distributors in a week, having distributors pay it 30 days upon receipt, and collecting bonus bank interest for as long as it’s holding onto its suppliers’ cash.
What you actually want, is to look at the company’s activities from the viewpoint of: “Here’s a blackbox I can throw $x into, and get $x back plus $y profit after z time.”
In the case of a bank account, x = whatever amount you put in, y = interest rate, and z = month. In order to compare that, you’d want equivalent figures for the company. But then beware of not comparing apples to oranges while doing so.
For instance, if spending $1k on AdWords each month yields $2k of extra profit during the same time period, the naive thing to compare the interest rate to at first glance is a 200% ROI. If it meant spending $10k extra in salaries and what have you in order to get $12k extra in sales, for $2k of profits, you should actually looking at $2k profits / ($10k + $1k expenses) – an 18.2% ROI. (And note that things could get thornier still if we dove into indirect costs.)
The problem then becomes that these figures aren’t readily available for you to compare: it’s confidential information. And this assumes the information is available at all to begin with. Small and medium-sized companies seldom bother working out the specifics for individual activities. Those that do, and larger corporations, tend to only have a vague idea of their own costs and ROIs, because computing very precise figures involves a great deal of scientific accounting finesse.
Some proxies can be tempting, but keep in mind that companies can use leverage, and can have all sorts of colorful entries on their balance sheets. If, for instance, you run the above example, with the additional assumption that you’re actually using a bank loan to leverage $2k on hand into $10k + $1k, which you then use to generate and cater to $22k in sales, and pocket a $2k profit after paying the loan back, the ROI shoots up to 100%. (Yes, that was free money, but this was to illustrate the point.)
To conclude on all of this, it’s not simple. And we completely avoided discussing asset depreciation and the like. When you take these into account as well, I believe the precise term you’re looking for is the MEC, or marginal efficiency of capital, rather than ROI – in a nutshell, if your MEC is higher than interest rates, then it’s worth investing.
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