For any business, earning profit is important. But to become aware if the company is successful it needs to compare the ratio of the total profit that it makes to the cost of resources devoted (invested) to achieving a positive return. A positive return refers to earnings such as capital that outrun the investment amount. Investors use a metric called return on investment (ROI) to calculate this return.
What is a return on investment (ROI)?
Return on investment (ROI) is a financial metric that investors or businesses use to measure their level of financial success. ROI refers to comparing the ratio of the net profit from the investment to its cost.
Depending on the total return on the investment, the company receives information on how well it is managed. “Total return” refers to all returns on an investment, including capital gains and other financial rewards.
Although ROI is a ratio, it is usually expressed as a percentage and there are many ways to calculate it.
How to calculate ROI?
One of the ways to calculate ROI is investment gain divided by investment base, or ROI = Investment gain / Investment base.
But the most common way to calculate ROI is net income divided by the total cost of the investment, or ROI = Net income / Cost of investment x 100.
For example, if a person invested $80 into a business purpose and spent another $20 researching this purpose, the total cost would be $100. If that business purpose generated $300 in revenue but had $100 in personnel costs, then the net profits would be $200.
By using the formula above the net income which is $200 divided by the cost of investment which is $100, the answer is 2. But ROI is often expressed as a percentage so the result needs to be multiplied by 100. Therefore, this particular investment’s ROI is 2 multiplied by 100, or 200%.
Measuring the ROI of numerous metrics helps determine how profitable the business is each one of them.
However, some disadvantages are important to pay attention to.
What are the disadvantages of ROI?
- Different calculation methods – Due to the existence of different equations for calculating ROI, each business may use a different method, making the comparison between investments irrelevant.
- ROI does not consider time period – For example, comparing two investments. The one has a high ROI and the other has a low ROI, it does not mean that the investment with a higher ROI is better than the other. Since ROI does not consider the period of each investment, it is possible that it was different for the two investments.
- Only considers the financial benefits – When estimating the return on investment, ROI does not consider the non-financial benefits of the investment.
Despite the drawbacks of ROI, it has also its benefits.
What are the advantages of ROI?
- One of the biggest advantages of ROI is its ease of use. Thanks to the easy calculation, it enables analysis of the performance of an investment.
- Another benefit of ROI is the possibility of comparing returns from different investments.
Conclusion
For a business to be profitable, it needs to have a positive rate of return on investment. This means that the rate of return must be greater than the total cost. If the percentage is negative and the indicator against which the ROI is measured is less than the total costs, it means that it generates a loss.
