Return on Investment
Return on Investment Overview
In business, it is often said “it takes money to make money.” Return on Investment (ROI) is a profitability ratio that helps measure the performance of this application of money. ROI allows managements’ utilization of assets and overall company profitability to be measured. ROI measures the link between profits and the investment required to generate profits.
ROI is frequently used by management to measure performance against internal goals, competitors, or a specific industry. Management also utilizes ROI to determine where to allocate future resources based on previous investment’s profitability. ROI allows the return of investments generating different amounts of revenue to be compared. For example, an expensive piece of machinery may generate more revenue than a lower cost investment, but that lower cost investment may have a better ROI. ROI allows management to see past revenues, and view the effects of investment expenses on return.
In addition to internal users, external users such as investors, bankers, analysts, and other finance professionals, utilize ROI to evaluate financial strength and to assess companies use of resources.
Measuring Return on Investment
There are many ways to measure ROI because there are many ways to define what an investment is and there are different methods to determine revenue generated from a spefic investment. ROI is usually stated as an annualized return for a fiscal or calander year, unless otherwise stated. This article will focus on the general ROI calculation.
General Calculation: Net Profit/Total Investment x 100
This formula clearly measures the relationship between the costs and benefit of the investment. Specific investment costs and benefits must be determined when using this forumla. This is the difficult part of calculating ROI. Specific investment costs must be recorded and the specific monetary benefits of the investment must be determined. Calculating the ROI of technology, for example, can be difficult unless cost/benefit parameters are established.
Specific costs of an investment can become quite detailed and open to interpretation. Investment benefits and costs can be modified to fit a specific company or situation. If the same calculation criteria is applied to all ROI calculations within a company, than more meaningful investment comparison can occur.
This flexibility may be a downside for external analysts or financial statements users, as companies could modify the investment cost and benefit calculations to enhance results.
Conclusion
ROI is a useful tool for measuring management performance. When evaluating management using ROI, other information should be considered. For example a low ROI could result from a conservative business model rather than poor management.
External users comparing the ROI of different companies need to understand how each company calculated ROI to make sure the data is comparable.
ROI is a good method of measuring and comparing the earning power of investments. The versatility and simplicity of ROI as an evaluation measure and tool for deciding where to allocate capital also makes ROI a useful financial profitability ratio.
Related Sites:
The Analysis and Use of Financial Statements by White, Sondhi, and Fried
http://www.bnet.com/2410-13240_23-66470.html
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