How it’s assessed and why it matters to everyone in your institution
The Return on Investment (ROI): your CFO’s dream, the Board’s best friend, and usually the deciding factor on whether your idea becomes reality. ROI is not just how you determine whether or not a venture is financially viable, it’s how to determine what ideas are the highest and best use of limited resources available at your institution. It shows the per dollar return you achieve on cost and is a powerful tool to convince stakeholders that your idea is a well-analyzed and tangible solution.
ROI can be calculated as (Total Revenue - Total Cost) / Total Cost. It informs us of the percent yield we earned on the assets we deployed over a given period of time. Ideally, the ROI earned by your proposal adds value and contributes positively to the bottom line.
ROI isn’t standalone, it’s assessed relative to other important financial metrics at your institution. Typically the Board and Management will be executing strategies to maintain or reach a target return on average assets (ROAA) or return on equity (ROE). These are informed by three main items: 1) the net interest margin (NIM) or spread between the cost of deposits and return on assets such as loans or investments, 2) non-interest based fee income, and 3) non-interest based expenses.
Evaluating a program starts with market research. You need to understand the total addressable market (TAM), how much of that market the institution can feasibly support, and how long it will take to build market share.Typically you can expect the beginning phase of your new venture to operate at a low level of profit, or even in the negative while you scale up.
Once you’ve determined the addressable market, determine the type and amount of revenue that can be earned. Sources may include fee income, lending income, interchange fees, and other opportunities specific to the offering provided by your financial institution. Revenue may differ by different types of customers within the same industry, so make sure your revenue estimates accurately reflect the types of customers you will be engaging.
Breaking Down Cost
Cost is determined based on a variety of factors, typically software or other solutions in combination with the hourly wage of dedicated staff. In the below example the number of Full Time Employees (FTEs) increases as the program scales, as opposed to leveraging software that may reduce the time dedicated to certain processes. While we only look at the hourly wage of these employees there may be costs associated with hiring, training, facilities, or other operational processes that detract from profitability.
When discussing the scale of your program, look for ways to reduce cost with your increased size. Many times this is achieved through outsourcing to a third party or software solution. But it can also mean delegating lower skill portions of your program to lower wage workers, thus increasing your staff’s skillset while minimizing FTE driven expenses. While a software solution, partnership, or outsourcing arrangement will typically not be required, it can be a way to increase the per dollar return you earn.
Deploying the Highest and Best Use of Capital
In the above example, our new program is only earning non-interest fee income and incurring non-interest expense in the form of salary expenses. To analyze whether this program is a net contributor to financial performance, calculate the ROI. Both examples above have the same ROI, as we have not assumed any efficiencies were gained by scaling up. To calculate the ROI simply take (Revenue - Cost) / Cost, or ($92,400 - $24,451) / $24,451 and we find the project is yielding a 2.8 times return on contributed capital. Assuming this exceeds the average ROAA at your institution it would be contributing positively to financial performance.
If determining whether our project was viable with just this simple calculation, life would be a lot easier for the staff in your project analysis and finance divisions. One important, but less clear factor is risk. Financial institutions are in the business of assessing and taking risk. When determining the profitability of a new business line it is necessary to consider the financial cost of risk. In the case of a high-risk line those can be things like operational, legal, or compliance risks that have unclear but very real financial consequences. Your financial institution should compare the return gained by any new venture on a risk adjusted basis, to ensure that your increased returns are not overshadowed by an excessive propensity for loss.
Return on Investment isn’t as complicated as it seems, and it’s integral to the decision to pursue a new market, product, or service. When considering a new space, determine what the need is, how much of the market you can address, what the addressable market means for revenue, what the cost to your institution is at outset and at scale, and whether the risk adjusted return is adequate.