Return on Investment (ROI): Definition, Usage, Formula, and Example

Definition:

Return on investment is one of the profitability ratios used 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 different-sized investments as the measurement is in percentage rather than obsolete value. Return on investment is also popular in measuring the return on assets 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 measure the Division, 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, 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 invested for those specific projects or investment centers.

In general, the calculation and interpretation of ROI are straightforward; therefore, it is famous as most 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 anticipated cost of the project is $900,000. The annual ROI of the same task 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, which is lower than the ROI of the same project, which received 25%.

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

For example, ABC receives a 20% ROI or $200,000 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 company’s news that is 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 increased 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. This analysis will take example 1 as an example two is straightforward.

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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 yearly ROI of the same task is 25%, which means that the proposed project has a lower 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. Sometimes, the small project might have a better return and be accepted, yet the real value is minimal.

Technically, to make a proper assessment, Residual Income should be used along with ROI as RI shows the actual 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 could compare between project and investment in a different size.

However, ROI is the ratio that looks in the short-term period. The result could be significantly affected by accounting policies if those projects or investment management needs to.

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

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

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

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Written by Sinra