Determining whether financial ventures are generating
adequate returns is something of an art -- but there's a lot of
science to it, too.
To determine the value a project delivers, you need to understand
return on assets (ROA), return on equity (ROE) and return on
investment (ROI).
Robert C. Fink, an associate professor at Stonehill College in
Easton, Mass., defines ROA as the income a company generates during
normal operation divided by its total assets, which include cash,
inventory and computer hardware or software.
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Glossary
A few terms that may help you
understand measures of return:
Common equity: The value of company stock owned by
the public
Cost of capital: The money to fund a project -
includes interest on loans or the predicted benefit of doing
something else with the money.
Liability: Financial responsibility, including debt
and potential loss
Net income: A company's total earnings, with
adjustments for revenue and the cost of doing business
Return: The change in value of an investment over
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This calculation determines how well a company is using its
assets to generate income. An example of how information technology
assets generate income can be seen among e-commerce companies that
use servers for the essential transactional processes of buying and
selling goods and services online.
Another Approach
Others may think differently. Dewey Norton, vice chairman of the
committee on finance and information technology at the Financial
Executives Institute in Morristown, N.J., defines ROA as total
investment minus debts, expenses and other liability, with a portion
of long-term debt added back.
According to Norton, current liabilities can include money for
acquisition of IT inventory and other assets.
Norton says current liabilities should be compared with the cost
of borrowing money to cover these expenses to determine whether the
investment generates more money than the cost of financing those
investments.
Corporate ROA provides a benchmark for measuring the value of
investments such as IT systems, Fink says. Money spent on IT is
worthwhile if the additional income generated from using new IT
systems, minus the cost of those systems, is greater than the
average corporate ROA number for that industry.
The cost of an IT system doesn't include just the price tag plus
money spent on support or customer development, Norton says. When
determining the cost of an IT asset, a company should factor in
whether it requires the development of new technology. The company
should also consider how many people will need to work together from
various locations and if they have the project management skills to
complete a highly distributed project, Norton says.
What to Know About ROE
ROE, on the other hand, is a company's net income divided by the
total amount common stockholders have paid for stock in the company.
ROE is related to, yet distinct from, assets in ROA. To buy
assets, you need common stock owners to invest in your business or
loans to pay for things that cost more than the amount of cash on
hand at any time.
"ROE represents the return to the owners of your business that
the company has generated in the past year," Fink says. If a
company's stock is providing a good return for investors, an
e-commerce company, for instance, can use that money to make needed
IT investments, such as faster servers that can improve the speed of
service and, thus, the perceived value of the company.
ROI gets a little more complicated. According to Fink, there are
various ways to determine ROI. One way is to estimate the extra
money a new IT system will bring in, or its cost savings, minus its
cost and depreciation.
Overall, companies have several tools to calculate the return on
IT investments or how they will impact the bottom line. When
figuring the real cost of IT projects, Norton recommends that a
company factor in training and consider hiring a full-time project
manager to lower the risk that the investment may not produce the
return the company is expecting. He notes that most IT projects take
longer to complete than initially projected, and companies should
take care to add more development time to their expense and earning
projections.
"What is more important than calculation of respective returns is
what could go wrong and how severe the consequences are if you don't
get it right," Norton concludes.
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