ROI considered base is investment as operating assets but for residual income consider investment as net assets
ROI typically uses **operating assets** as the investment base, whereas residual income often considers the base as **net assets or equity capital**
## ROI Base: Operating Assets
- The denominator in ROI is generally the value of assets used in daily operations, such as property, plant, and equipment that are actively employed in creating income
- Example: ROI = Operating Income / Average Operating Assets. Assets not in day-to-day use, like land held for investment, are excluded
## RI Base: Net Assets or Equity Capital
- Residual income measures the excess operating income after accounting for the required return on the capital invested, often calculated based on net assets (total assets minus liabilities) or specifically on equity capital[4][3][5].
- Example: RI = Net Income – (Equity Capital × Cost of Equity) or RI = Net Operating Profit After Taxes – (Invested Capital × Cost of Capital)
### Distinction
- **ROI** focuses on total operating assets deployed[1].
- **RI** is generally measured on net assets or equity invested, emphasizing income above the cost of capital tied to those net assets
This distinction ensures that ROI is a measure of operational efficiency, while RI reflects value creation for shareholders after all costs—including opportunity costs—have been accounted for.
Let's break down the ROI and RI formulas with illustrations.
*Return on Investment (ROI)*
ROI considers operating assets, which include property, plant, and equipment (PP&E), inventory, and accounts receivable. The formula is:
ROI = Net Income / Average Operating Assets
*Illustration:*
Suppose a company has:
- Net income: $100,000
- Average operating assets: $500,000 (including PP&E, inventory, and accounts receivable)
ROI = $100,000 / $500,000 = 0.20 or 20%
This means the company generates a 20% return on its operating assets.
*Residual Income (RI)*
RI considers net assets, which include fixed assets and net working capital (NWC). NWC is calculated as operating current assets minus operating current liabilities. The formula is:
RI = Net Income - (Cost of Capital x Net Assets)
*Illustration:*
Suppose a company has:
- Net income: $250,000
- Fixed assets: $600,000 (property, plant, and equipment)
- Net working capital: $200,000 (accounts receivable + inventory - accounts payable)
- Cost of capital: 15%
Net Assets = Fixed Assets + Net Working Capital = $600,000 + $200,000 = $800,000
RI = $250,000 - (15% x $800,000) = $250,000 - $120,000 = $130,000
This means the company has a residual income of $130,000 after covering the cost of capital.
*Key differences:*
- ROI focuses on operating assets, while RI considers net assets (fixed assets + net working capital).
- ROI measures return as a percentage, while RI measures the absolute residual income after covering the cost of capital.
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