Definition:

Return on investment is one of the profitability ratios that use to measure the percentage of investing profits over the invested fund.

Return on investment is popularly used for assessing the performance of investment centers, profit centers, investment projects, and companies.

The main principle of return on investment is how much profit that investments project could earn compared to invested funds.

This is quite useful for investors to assess return on their investments in different sizes as the measurement is in percentage rather than obsolete value. Return on Investment is also popular in measuring the return on investments of shares in the stock market.

Related: Return on Assets

Return on Investment Formula

Return on Investment Book
Return on Investment Book

The formula of

Return on Investment = (Investing Profit/ Investment fund)

Some book said

ROI = (Investment Revenue – Investment Cost)/Investment Cost.

These two ways are the same thing.

If you are measuring the Division, then the ROI is Divisional Profit/Divisional Investment.

You can also calculate the

ROI = Profit Margin * Assets Turn Over

While

Assets Turn Over = Divisional Assets / Divisional Investment

And

Profit Margin    =   Divisional Profit / Divisional Sales

If you start with Investment Revenue, then you have to find the investment profit. Investment Profit is the same as Operating Profit. Investment Profit is equal to investment revenue less Investment Cost.

The Investment Cost or Investment Fund is the total cost or fund invests for those specific project or investment center.

In general, the calculation and interpretation of ROI are simple and straight forward; therefore, it is popular as most of the non-accounting managers could easily understand.

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Return on Investment: Example and Calculation

Example 1:

ABC Company is considering investing in the new project in which the expected net profit of investment will be $200,000 per annual for five years. The expected cost of the project is $900,000. The annual ROI of the same project is 25%.

Answer 1:

  • As per example, the Investment Profit is $200,000, and the Investment Fund is $900,000.
  • Therefore, ROI is 200,000/900,000 = 22% per annual.

As a result of our calculation, the current ROI is just 22% percent and this is lower than the ROI of the same project which received 25%.

However, there are many factors that we need to consider when assessing the performance based on ROI.

For example, ABC receives a 20% ROI or $200,000 in profit. How about the project that receives 25%? How much profit does it generate?

Example 2:

ABC Company decided to purchase a share from the news the company that investing in the agricultural product.

The share price at that time was $500 per share and ABC purchased 500,000 Shares. Three years later, the share price increase to $600 per share and now ABC is planning to sell its entire share.

What is the Return on Investment of ABC Company?

Answer 2:

Now let calculate the total revenue, and cost of the shares from the sale.

  • The total revenue = 600*500,000 = 300,000,000
  • The total Cost of investment = 500,*500,000 = 250,000,000
  • Return on Investment = (300,000,000 – 250,000,000)/ 250,000,000 = 20%

Return on Investment: Interpretation and Analysis

Now let perform an analysis of this ROI. In this analysis, we will take the example 1 as example two is straight forward.

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In example 1, the annual ROI is 22% and in this case, you can calculate the ROI of the whole life cycle of the project. The annual ROI of the same project is 25% and this means that the project being proposed has low ROI than the same project. In this case, the project might not accept.

However, as you can see, the ROI uses the percentage as the measurement. Sometime, the small project might have a better return and it is accepted, yet the real value is very small.

Technically, in order to make a proper assessment, Residual Income should be used along with ROI as RI showing the real value of the return.

Advantages Disadvantage of Return on Investment in Performance Management

ROI is easy to calculate and the result of calculation could understand by non-accounting managers. This is one of the most advantages. ROI using the percentages and it could compare between project and investment in a different size.

However, ROI is the kind of ratio that look in the short-term period, and also the result could be significantly affected by accounting policies if the management of those project or investment needs to.

Using Return on Investment, a small project which has a high return rate might accept while the big project that has a low rate but huge in value might reject.

The real amount that added to the shareholders is the real value, not the percentage. In most of the case, when using ROI as the performance indicator for assessment, RI is always the one that accompanies it.

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The main reason is that RI shows the result in the real value rather than a percentage. Another indicator that could be used is the Net Present Value or Economic Added Value. These two indicators show the real value added to the shareholders while EVA is less affected by accounting policies.

Written by Sinra