Return on Investment(ROI) is a mathematical metric used by investors to measure the performance of their investments. Most ROIs calculations are done to compare the returns generated from several investments made. Have you ever heard about ROI? Well, in this article you will learn what Return on Investment means and how to accurately calculate ROIs.
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As stated in the first paragraph, Return on Investment is simply a mathematical calculation that serves as a performance indicator of an investment. The ROI result is used to determine the efficiency and profitability of an investment.
Why is Return On Investment necessary?
ROIs are important calculations that serve in the evaluation of investment options. This evaluation helps an investor in determining which investment works best and make better investment decisions.
- Return on Investment(ROI) can be used to determine how well a business is managed. Because ROI is the ratio of the returns and the cost spent on investments, companies can effectively assess their profits and also their company expenditure.
- The good thing with ROI is that it can also be done before an investment is made but the risks and associated costs that would be incurred will have to be factored in. ROI calculations here will enable better investment decisions that have lesser risks for both companies and individuals.
- ROI is an efficient profitability formula used by businesses to monitor the sales and profits made.
Benefits of using ROI
Below are the benefits of using ROI
Ease of calculation
The ROI formula requires a few figures to be inputted. These figures can be easily obtained from financial statements. Also, the result which is usually expressed as a percentage is easy to interpret.
Enables efficient comparative analysis
ROI compares the ratio of loss or gain and it can be used between several investments. Can compare present, past and even future returns.
- The result of ROI is easy to understand by both experts and unlearned individuals as it is mostly plain figures.
- ROI is effective in measuring the performance of an investment, business or project and it also helps in formulating better counter-reactive strategies to ensure success.
How to Calculate Return on Investment (ROI)
There exist several methods of calculating ROI but the most common methods are the net income method and the capital gain method.
In this article, we will be considering only these methods because they are the most common, most used methods which are easier to calculate plus the result which is expressed as a percentage is easy to interpret.
- The net income method is the ratio of the net returns and total cost of investment which is represented as ROI = (Net returns ÷ Cost of investment) × 100
Here is an example to illustrate this method of Return on Investment(ROI) calculation.
Let’s say, an individual invested a sum of 90,000 naira in a stock purchase but also spent 10,000 on a service broker he used during the process.
The total cost = is 100,000 naira. Over time the stocks generate 250,000 in revenue but also 100, 000 was spent on other expenses, the net return will be 150,000.
For the net income method the ROI here will therefore be; 150,000÷ 100,000, the answer for this quotient will further be multiplied by 100. The ROI will be 150%.
- The Capital gain method – ROI = (Current Value of investment – the cost of investment) / cost of investment x 100
From the above example question, the capital gain method ROI will be; 150,000 – 100,000 / 100,000 × 100. The ROI will be 50%
How to Interpret Return on Investment
When a Return on Investment is said to be in the red this suggests that the investment incurred a loss, an ROI on a black implies investment profitability which is usually positive. An ROI on the red usually has a negative value.
Still, despite the ROI result what is considered to be a good ROI is different on the type of business and industry. Therefore, it is important to know the standards that apply to your industry before reaching a conclusion
Limitations of ROI
ROI is a great way of checking out and determining a good investment decision, still there exist a few limitations.
One limitation of ROI is that the length of time is not determined. Thus, it is impossible to know if your ROI result on your investment is worth the time your investments have been held for. This implies that when comparing 2 investments of which one is at a shorter duration and the other was held for longer, a comparison might not be effective. A solution for this would be the use of Annualized Return method as it considers the number of years.
Another limitation of ROI is that there exist several methods of ROI calculations and it could be confusing when used interchangeably or by different persons(companies and investors) because different results will be produced. However, this limitation could be resolved by sticking with one ROI calculation for both parties.