Introduction to Return on Investment Ratio
Return on Investment ratio can be defined as a financial tool that helps in the evaluation of the investment efficiency as it calculates the percentage of earnings of an investment which is calculated using mostly the two elements where the first element is net profit and the other one is the cost of investment.
There are various methods to calculate the return on investment. Using the most popular formula return on investment will be calculated as
Net return is the net profit earned on the investment when the investments are sold. These figures can be taken from the Income statement of the company. The cost of Investment is the total amount of money for which the investment was purchased or it is the cost paid for the investment. This figure can be taken from the Balance sheet.
The return on investment is a financial measure or a simple ratio that shows the percentage of return earned on the investment made. In a business financial analysis ROI is an important metric used to rank the different number of investments available on the basis of their percentage of earnings. The ROI is always expressed in a percentage form.
The return on investment measure is used for knowing the potential earnings of an investment. ROI helps in doing the comparison on the basis of the profitability of the available investment opportunities. The investment that has the maximum ROI among the different investments available is always prioritized. The return on investment considers the elements of earnings and the cost of investment which helps in the analysis of how much potential investments have in terms of profitability.
Example of Return on Investment Ratio (With Excel Template)
Let’s take an example to understand the calculation in a better manner.
A person wants to invest in the shares of a company. He purchased 100 shares at the price of $500 each and after sometime purchased 100 shares again of the same company at the price of $550 per share. After a few years, it sold all the 200 shares at the price of $600 per share. Calculate the return on investment ratio of the person.
Cost of Investment is calculated using the formula given below
Cost of Investment = Purchase Price *Quantity Purchased
- Cost of Investment = $500 * 100 + $550 * 100
- Cost of Investment = $50,000 + $55,000
- Cost of Investment = $105,000
Net Return is calculated using the formula given below
Net Return = Sales Value of Investment – Cost of Investment
- Net return = (200*600) – $105,000
- Net return = $120,000 – $105,000
- Net return = $15,000
Return on Investment Ratio is calculated using the formula given below
Return on Investment Ratio = (Net Return /Cost of Investment) * 100
- Return on Investment Ratio = ($15,000 / $105,000) * 100
- Return on Investment Ratio = 14.29 %
Analysis: By investing the money in the shares, the investor earned the 14.29 % return on investment.
Difference Between Return on Investment vs Return on Equity
ROI is a percentage of profit earned on the given investment which is calculated by dividing net profit earned (sale value of investment – cost of investment) from the cost of investment and then multiplying the figure from 100 whereas ROE is a measure to calculate the percentage of return earned on the shareholders’ investment in the company and is calculated by dividing net income (Revenue – Expenses) of the company from the total shareholders’ equity (total assets – total debts).
Advantages and Disadvantages of Return on Investment Ratio
The advantages and disadvantages are discussed as follows:
The disadvantages are discussed as follows:
- The ROI ensures that the business is investing its funds in the asset that will give the required earnings to the investor. ROI helps in doing the investment at its optimum level where the investors can achieve the maximum earnings.
- With the help of ROI, the investor can do the comparison on the basis of the earning potential of the various investment opportunity options that are available for investing the available funds.
- ROI acts as a benchmark for the measurement of the company’s managing efficiency and is significant for measuring the efficiency of the investment decisions taken by the investment division of the company regarding the acquisition and demolition of the assets of the company.
The disadvantages are discussed as follows:
- The comparison of the different companies on the basis of their return on investment ratio might not give the proper results because there are chances that the companies follow different accounting policies, methods, etc for the valuation of their investments. Thus the comparison on the basis of ROI should be done only between the companies that follow the same accounting principles, methods, policies, etc.
- Many times, the managers of the company select the investment on the basis of its return on investment ratio, but this ratio focus on the short term profitability and does not focus on the long term profitability. It considers only the cost and returns of the period under consideration and ignores the effect of such investments for the long term so, managers might avoid the investments whose ROI is low but in long term, they might beneficial for the company and increase the value of the business.
- The risk pertaining to the investment is not considered by the ROI and it only measures the return on such investment.
Return on investment ratio is a ratio which calculates the percentage of return earned by the person out of its investment for the period. Since it is part of an analysis of profitability ratio, it is one of the useful tools for the person that wants to invest their money in some investment areas. However, if the comparison between the companies and business decision making is to be done using the return on investment ratio, then along with it other factors should also be considered in order to make effective decision making.
This is a guide to Return on Investment Ratio. Here we discuss how to calculate return on investment ratio along with a practical example. we also provide a downloadable excel template. You may also look at the following articles to learn more –