Return on investment (ROI) is a financial ratio that measures the profitability of an investment. It is evaluated by dividing the net profit by the investment cost. In other words, ROI shows how much profit a company has earned on an investment relative to the cost of that investment.
ROI can be calculated as a percentage or as a ratio. For example, an ROI of 20% means that for every rupee invested, the company earned 20 cents in profit. A ratio of 2:1 implies that for every rupee invested, the company earned two rupees in profit. ROI is commonly used to evaluate a company’s financial performance or compare the profitability of different investments.
ROI can be calculated for any investment, such as a capital expenditure, a marketing campaign, or a research and development project. However, the formula for calculating ROI remains the same:
Where:
- NP (Net Profit): The total profit earned from the investment, including any gains or losses. This is calculated by subtracting the investment cost from the total return on investment.
- COI (Cost of Investment): The total investment cost, including direct and indirect costs.
Interpretation of ROI
ROI is a measure of profitability and can be interpreted differently, depending on the context. A higher ROI is generally better, as it indicates a higher return on the investment. However, the interpretation of ROI depends on the specific investment and the industry in which it operates. For example, a 10% ROI may be considered low in some sectors but high in others.
ROI can also be used to compare the profitability of different investments. When comparing two investments, a higher ROI indicates a better return on the investment. However, this comparison is only valid if the assets have similar risk profiles and time horizons.
Significance of ROI
Return on Investment (ROI) is a financial indicator that determines the profitability of an investment. It is a popular statistic for assessing investment possibilities and making financial decisions. Here are some of the significant benefits of using ROI:
- Helps make investment decisions: ROI measures an investment’s profitability, allowing investors to reach informed decisions about investing in a particular opportunity.
- Facilitates comparison: ROI may be used to assess the profitability of various investment opportunities, making it easier to choose the best investment option among multiple options.
- Helps in monitoring performance: ROI allows investors to monitor the performance of their investments over time, enabling them to make timely adjustments to their investment strategy.
- Helpful in setting financial goals: ROI provides investors with a clear target for achieving them. By placing a specific ROI target, investors can focus their efforts on achieving the desired level of profitability.
- Useful for financial planning: ROI is an essential metric for financial planning, as it helps investors to forecast future profits and estimate the potential returns on their investments.
- Helps in measuring efficiency: ROI can be used to measure the efficiency of a company’s operations by comparing the profit generated with the amount of capital invested.
- Helpful in evaluating business performance: ROI is a valuable tool for assessing a business’s overall performance. By analyzing the ROI of different departments or business units, managers can identify areas for improvement and implement strategies to increase profitability.
Limitation of ROI
Return on Investment (ROI) is a widely used metric to evaluate the financial performance of a business. However, ROI has some limitations, and it is essential to remember them when using this metric to make financial decisions. Some of the limitations of ROI are:
- ROI does not consider the time value of money: ROI is a simple calculation that only compares the return on investment with the amount invested. It does not consider the time value of money, which is the concept that money today is worth more than the same amount in the future. This means that ROI may not accurately reflect the profitability of an investment over time.
- ROI does not account for risk: ROI does not consider the risk associated with an investment. Two investments may have the same ROI, but one may be much riskier. An investor should consider the risk associated with an investment before deciding.
- ROI does not consider other factors that affect the financial performance of a business: ROI is only one metric used to evaluate a business’s economic performance. Other factors such as cash flow, debt-to-equity ratio, and revenue growth rate also play a significant role in determining the financial health of a business. Therefore, ROI should not be the only factor considered when making financial decisions.
- ROI may be manipulated: ROI can be used by adjusting the calculation inputs. For example, an investment may appear more profitable if the cost of the investment is understated or the expected return is overstated. Therefore, verifying the inputs used in the ROI calculation is essential to ensure accuracy.
- ROI may not be comparable across different industries: Different industries may have other benchmarks for ROI. For example, the ROI for a software company may be higher than the ROI for a manufacturing company. Therefore, comparing the ROI of companies in different industries may not be appropriate.
For example, let’s say a company invests Rs.10,000/- in a marketing campaign and generates Rs.15,000/- in sales revenue as a result. The total campaign cost, including salaries, materials, and other expenses, is Rs.5,000/-. The net profit is computed by subtracting the cost of investment from the total return on investment:
Net Profit = Total Return on Investment – Cost of Investment Net Profit
= Rs.15,000 – Rs.5,000
= Rs.10,000/-
Using this information, we can calculate the ROI of the marketing campaign:
This means the company earned one rupee in profit for every rupee invested in the marketing campaign, resulting in an ROI of 100%.
Examples of ROI
A stock investment:
Suppose you invest Rs.10,000/- in a company’s stock, and after one year, you sell the stock for Rs.11,000/-. The net income from the investment is Rs.1,000/-, and the total capital invested is Rs.10,000/-. Therefore, the ROI is calculated as follows:
A real estate investment
Suppose you purchase a rental property for Rs.2,00,000/- and earn Rs.20,000/- in rental income after expenses in the first year. The net income from the investment is Rs.20,000/-, and the total capital invested is Rs.2,00,000/-. Therefore, the ROI is calculated as follows:
A marketing campaign
Suppose a company spends Rs.1,00,000/- on a marketing campaign and earns Rs.2,00,000/- in additional sales revenue. The net income from the investment is Rs1,00,000/-, and the total capital invested is Rs.1,00,000/-. Therefore, the ROI is calculated as follows:
Finally, return on investment is a fundamental financial ratio that assesses an investment’s profitability. ROI is a simple and effective technique to analyze a company’s or investment’s financial success by comparing net profit to the cost of the investment. However, it is crucial to use ROI with other financial metrics and consider this ratio’s limitations when making investment decisions.
Dr. Utkarsh Amaravat is a banker with vast experience in retail credit. He holds a B.E. Mechanical and MBA Marketing degree from Gujarat Technological University and a Ph.D. in management (Credit Risk Management) from Sardar Patel University. He has mainly experience in sales and processing of credit proposals. Sales/Marketing, Relationship Management, Credit, and Risk Management, including research work are vital domains for him.