Return on investment is often abbreviated as ROI. It is a profitability measure. It is one of the most profitability ratios. It is the tool with help of which we can find the net profit eared from each of the investments. We can find out how much cost saving (profit) is realized for a given use of money. This is a performance measure. It is applied for the efficiency evaluation of investment. It is also used for efficiency comparison of several investments. So, ROI is the benefit which results from the investments. If the ROI is high, it means the gain compare favorably to cost of investment. It measures the gain/loss on an investment. The measurement of gain/loss is relative to the money invested amount. It is expressed as a percentage. It is used for personal financial decisions. It is also used to compare the profitability/efficiency of investments.
Return on Investment Formula
ROI = (Net Profit/Cost of investment) X100
The ROI calculation is flexible. There can be manipulations for uses. It can be used for comparison of ROI for different investments. It can also be used to calculate return on a stock.
Suppose Jack is an investor. He buys stocks worth of $1000. Two years later he sells the share for $1200. So, there is a $200 net profit from investment. According to the formula:
ROI = (200/1000) X100= 20%
The purpose of ROI is to measure the rates of return on the money which is invested in an economic entity. It is done to decide if the investment should be undertaken or not. It is sometimes compared with rate of return. It can be calculated other than financial gain. Social return on investment method is sued for extra financial value. It can also be applied to evaluate impact on the stakeholders. It can be sued to identify for performance improvement. It is helpful in performance enhancement of investments. It can be used for pricing policies, capital equipment investment etc.
Another way to calculate ROI is:
(Return – Investment) / (Investment)
Before we start ROI calculations, we need:
- Cost of Goods Sold: It is the cost to produce service/product.
- Marketing Investment: The cost of media (doesn’t include production cost)
ROI is very flexible. So it is most wide used profitability ration. It is simple to understand. So, it simply allows selecting variables freely.
When we talk about a single – period review, we divide the return by resources (investments). The return is net profit.
ROI (%) = (Net Profit/Investment) X100
Net Profit can be calculated as: Gross Profit – Expenses
Investment can be calculated as: Stock + Market Outstanding + Claims.
Another way is
ROI = (Investment Gain – Investment Cost)/Investment Cost
Many times, complications can be experienced in ROI calculations. One case is when there is refinance of real property. Second case is when a second mortgage is taken out. There can be more complex calculations. Net profit and investment level both are influenced by marketing. So, marketing decisions can affect inventories, accounts receivable, new equipments etc.
ROI is an important financial metric. It is for asset purchase decisions. These decisions can include purchase of service, vehicle, machinery etc. Traditional investment decisions are based on ROI. Return on Investment is also used as a measure of divisional performance. So, it is used for divisional comparison of different sizes. It focuses on central business objective. It makes the best profit possible on the available capital. Where authority is decentralized, return on investment is quite effective.
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