What is Return on Investment (ROI)
Return on investment (ROI) is a profitability performance measure, which is used to measure the efficiency of an investment. It measures earnings with respect to the particular invested amount. ROI is usually expressed in percentage.
The formula for return on investment is
Return on Investment (ROI) = (Net profit / the cost of an investment) * 100
How it Works (Example)
Mr. Smith buys $2000 worth of stocks and sells them after one year for $ 2500. The net profit from investment is $ 500 ($500 = $2500 – $2000) and return on investment will be calculated as follows:
ROI = ($500 / $2500) * 100 = 20%
ABC Company invests $1000 in project A and $1200 in project B. The profit at the year end from project A and B are $200 and $ 150. The company pays tax at 30%.
ROI from Project A:
Tax on profit is $200 @ 30% = $60 so net profit will be $140
ROI Project A = ($140 / $1000) * 100 = 14%
ROI from Project B:
Tax on profit is $150 @ 30% = $45 so net profit will be $105
ROI Project B = ($105 / $1200) * 100 = 8.75%
Management can easily measure efficiency of both projects from above ROI calculation to take future decisions.
Why it Matters (Analysis, Significance & weakness)
Usually, a positive ROI means that an investment has performed well and a negative ROI means that revenue was not enough to cover investment cost. Comparison of two different projects can be made to check which project perform well, in our previous example project A perform well with ROI of 14% greater than project B.
Return on investment calculation can be tailored according to need, it can be used:
- To measure divisional performance of a company
- To compare different investment project
- To measure profitability of a company as a whole
- To measure personal investment of an individual
Other similar profitability measures are, return on assets, return on equity, and return on capital (ROCE) etc.
ROI calculation may vary among users because of its flexibility, it may cause confusion.
It does not consider the time value of money, However, the formula can be altered with respect to present value calculation.