Return on Investment (ROI): An examination of ROI financial analysis and its historical roots with the DuPont Company Like it or not, with the current state of the economy, as well as, enforced implications of the Affordable Care Act, a large number of hospitals and healthcare agencies will close their doors for good this year. Perhaps the most common cause of these closures will be the result of inadequate financial performance. Like any business entity, it is the lack of proper financing that ultimately kills any healthcare organization. There is a basic fundamental principle of finance that no healthcare organization can ignore; ultimately, the organization must generate a return from its investment that at least equals the cost of the financing supporting that investment. If the overall return on investment (ROI) is not equal to greater that the organization’s cost of funds, financial failure will occur (Cleverley, 1990).
ROI has been an essential aspect of financial accounting ever since a group of financial experts at E.I. du Pont de Nemours and Co. (DuPont) invented the concept in the early part of the century (Southerst, 1993).
DuPont’s concept of financial analysis has recently become a model used by many businesses to evaluate and visualize the critical factors that contribute to ROI and hence shareholder value (Stavros, 2005).
The purpose of the following report is to examine the general financial concept of the Return on Investment (ROI) and its historical roots with the DuPont Company. It is critical that a healthcare organization first understands how much investment is needed to meet or maximize the organization’s mission, as well as, what mix of equity and debt will be used to finance the organization’s required investment. Return on Investment (ROI) is the prime financial criterion utilized to evaluate the desirability of capital investment in a business.
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Healthcare organizations seriously need to carefully examine their return-on-investment levels because the potential loss of capital cost payment in a government supplementary program like Medicaid/Medicare and the removal of tax-exempt financing would raise the effective cost of capital to the organizations (Cleverley, 1990).
In basic terms, ROI analysis, often times called a cost-benefit analysis, seeks to estimate and compare costs and benefits of an undertaking. The ROI analysis can be used in any or all of three ways: as a planning tool in choosing among alternatives and allocating scarce resources among competing demands; as an evaluation tool to study an existing project or service; or as a way to develop quantitative support in order to politically, economically or socially influence a decision. There are five methodologies associated with ROI that a healthcare organization may use: maximize benefits for given costs; minimize costs for a given level of benefits; maximize the ratio of benefits over costs; maximize the net benefits (present value of benefits minus the present value of costs); and maximize the internal rate of return on the investment (Matthews, 2011).
When assessing the desirability of a new investment and/or investments, traditional capital budgeting techniques are typically applied.
Usually this means comparing the present value of discounted future cash flows before financing expenses with the investment cost of the project. A project with a positive net present value promises an ROI that exceeds the organization’s cost of capital. From a financial perspective, assessing the desirability of continuing operations in a given business segment is fairly straightforward. The main and sometimes sole standard against which the continuation decision should be weighed is the ROI. The appropriate measure of investment and the business segment’s cash flow before financing expenses should be related (Cleverley, 1990).
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These basic fundamental principles can be seen today in various investment ventures and they have extensive historical roots spawning from E.I. du Pont de Nemours and Co., also known as the DuPont Company. Developed originally in the early 1900s by a finance executive at E.I. du Pont de Nemours and Co., of Wilmington, Delaware, the DuPont system of financial analysis provides a classic template for the decomposition process that can be used to build integrated systems of performance metrics. The traditional role that the DuPont formula plays in finance is to help investors select projects and investments that are the most profitable.
The first application of the DuPont Model was in 1918. It was used to help with DuPont’s decision to become a major stakeholder in General Motors (Mitchell, Mitchell, & Cai, 2013).
The DuPont accounting labs exported their ROI measure during Pierre du Pont’s reign from 1920 to 1923 as president of General Motors Corp., in which DuPont had taken a major stockholding. At GM and across corporate North America, ROI has since formed the basis of financial control (Southerst, 1993).
Over the years, it has evolved into a classic diagnostic tool for identifying strengths, weaknesses and potential improvements to a business’s capital structure in order to maximize shareholder wealth. (Mitchell, Mitchell, & Cai, 2013).
The DuPont model uses certain inputs such as sales, cost of sales, fixed assets and current assets. At successive stages they are added, subtracted, divided or multiplied until return on equity is reached. The model forms an easy to use and understandable framework with which to investigate the root cause of insufficient value creation. Furthermore, the model can be “instructive on ways to increase return on investment: increase sales-either by increasing the price or by selling more units, or decrease cost of sales, fixed assets and current assets.
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That is why within asset-intensive businesses, such as utilities, the model has particular significance (Stavros, 2005).” The reemergence of the DuPont model comes from financial executives who have found new value in adding growth measures to return on investment calculations (Stavros, 2005).
As a result of heavier debt loads, the uncertainty of asset values and the high cost of restructuring for a global economy, DuPont has recently switched to a new system based on cash flow called cash return on investment or CROI. DuPont’s conversion to cash flow marks a turning point for corporate accounting. In 1981, when DuPont acquired the former Continental Oil, now Conoco Inc., for US$7.6 billion, the conservative DuPont conglomerate, which traditionally carried little debt, suddenly found itself concerned with interest coverage; a measure of whether a business brings in enough cash at the till to pay the ongoing interest charges on its debt. When DuPont took on significant debt from the acquisition, not to mention its relentless operating environment, the company decided to transition into the CROI system of financial analysis.
In CROI’s simplest form, DuPont calculates cash inflow from after tax income by adding back depreciation, a working capital interest charge and new cash investment in the business (Southerst, 1993).
Ultimately, there are numerous financial ratios that are habitually used in the world of business; however, utilizing the DuPont Model of financial analysis to calculate ROI allows businesses, especially healthcare organizations, to break the organization’s profitability down into component parts to see where it actually comes from. The ROI calculation is particularly significant because it ultimately describes the rate of return a company is able to receive based on the assets that it had available that year. The expansion of the basic ROI calculation occurred in the early 1900s by financial analysts at E.I DuPont de Nemours & Co. and the theory came into practice when it was found that profitability from sales and the utilization of assets to generate revenue were both the important factors when assessing a company’s overall profitability. The world of business and its inhabitants should be very grateful for the DuPont Company and its model for ROI.
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Reference
Cleverley, W. (1990).
ROI: Its role in voluntary hospital planning. Hospital & Health Services Administration, 35(1), 71. Retrieved from http://ezproxy.sju.edu/login?url=http://search.proquest.com/docview/206708098?accountid=14071 Matthews, J. R. (2011, Winter).
What’s the return on ROI? the benefits and challenges of calculating your library’s return on investment. Library Leadership & Management (Online), 25, 14-1A,2A,3A,4A,5A,6A,7A,8A,9A,10A,11A,12A,13A,14A. Retrieved from http://ezproxy.sju.edu/login?url=http://search.proquest.com/docview/898969805?accountid=14071 Mitchell, T., Mitchell, S., & Cai, C. (2013).
Using the DuPont decomposing process to create A marketing model. Journal of Business & Economics Research (Online), 11(11), 485. Retrieved from http://ezproxy.sju.edu/login?url=http://search.proquest.com/docview/1458944503?accountid=14071 Southerst, J. (1993, 11).
The smart money’s on cash. Canadian Business, 66, 59-61. Retrieved from http://ezproxy.sju.edu/login?url=http://search.proquest.com/docview/221364093?accountid=14071 Stavros, R. (2005).
A NEW PERFORMANCE STANDARD. Public Utilities Fortnightly, 143(9), 33-34. Retrieved from http://ezproxy.sju.edu/login?url=http://search.proquest.com/docview/213216426?accountid=14071
