When you make any investment, you want to ensure that it's well thought out and strategic. You also want any investment to provide a financial return, allowing your money to work for you. Understanding what return on investment (ROI) means can help you better evaluate the profitability of a business or investment. In this article, we discuss the answer to the question "What is ROI?", learn the benefits of return on investment and the formula for how to calculate it, uncover the limitations of this financial ratio, learn about the types of returns on investments, and understand the various areas of business that use ROI to make strategic decisions.
What is ROI?
To answer "What is ROI?", it's first important to understand the initialism for the business term "return on investment." A return on investment is a measurement of the benefit or profitability of a specific investment related to the investment's cost. The type of investment depends on the area of business you're evaluating. For example, you can calculate the return on investment of shares purchased in a company or assess the impact of a business process, such as marketing or training and development of employees.
Why is an understanding of return on investment essential?
Understanding return on investment is an essential element in making strategic financial decisions. Return on investment is a popular metric of profitability used to determine how well your investment has performed. The result of a return on investment calculation allows you to compare similar investments to identify which is doing better. It also allows you to compare the efficiency and effectiveness of your investment strategy.
How to calculate return on investment
The basic calculation for return on investment is:
ROI = (net return on investment / cost of investment) x 100
The calculation allows the return on investment to show as a percentage amount, aiding in the comparison of various investments to each other. Follow these three steps to calculate your ROI:
1. Calculate the net return on investment
The first step to calculating return on investment is to determine the net return on the investment. To complete this, you need to know the initial cost of the investment and the current value. You subtract the current value from the initial price to come up with the net return on investment. For example, suppose you had a building that you purchased for $200,000. This is the initial cost of the investment. You then sold the property and received a purchase price of $350,000, or the current value.
Current value of investment - initial cost of investment = net return on investment
$350,000 - $200,000 = $150,000'
2. Divide net return by the initial investment
Now that you know the net return on the investment, you can now complete the bulk of the return on investment calculation. To calculate the return on investment, you divide the net return by the cost of the investment. Again, using the example above, we have the following information. We know that the net return on investment is $150,000 and that the initial cost was $200,000. Therefore, the calculation looks like this:
net return on investment / cost of investment = return on investment
$150,000 / $200,000 = 0.75
3. Multiple by 100
The last step to determining a return on investment calculation is to multiply your result by 100 to convert it into a percentage. You read a return on investment as a percentage instead of a ratio. This makes the results easier to interpret and understand. Again, using the original example, to finalize the calculation, you take 0.75 and multiply it by 100:
(Net return on investment / cost of investment) x 100 = return on investment
($150,000 / $200,000) x 100 = 75%
Limitations of ROI calculations
When determining the return on investment, there are several limitations that this calculation presents, including:
Investment holding period
When determining the return on investment only by looking at the basic information, the calculation doesn't consider the holding period of the investment. For example, suppose you have two assets. The investment held for a more extended period also had a longer return on investment. The lower ROI was for the short-term investment. If you were to compare the long- and short-term investments and their associated return on investments, it could provide misleading information without knowing the time frame.
The primary return on investment calculation doesn't consider the amount of risk associated with the financial investment. For example, suppose you have put money into a high-risk investment in the stock market. In this case, you want to account for potential fluctuations. To do this, you would use a calculation for risk-adjusted return, which can measure the profit of your investment relative to the level of risk over a specified period.
Potential for exaggeration
The return on investment calculation leaves room for error when determining the current value of the investment. This, in turn, allows the potential for exaggeration in the result. For example, suppose that you were trying to determine the return on investment of an expansion in your company. The current value or benefit of the development may not have specific financial or tangible results, and you extrapolate the data from the available information. This can be subjective and result in exaggerated or ballooned projections on the return on investment of a project.
Types of returns on investments
When looking at returns on your investments, there are three types of financial compensation you can make. These types include:
One way of receiving financial compensation on your investments is through interest paid to you. Savings account balances and bonds commonly pay out interest income. For example, for every $100 held in a savings account, the financial institution pays out 1.25% interest. So if your company has an investment of $50,000 in savings at an interest rate of 1.25%, you receive a return on investment of $625 for the month of that balance.
A capital gain is the amount of money you receive after selling an asset for more than you paid. In contrast, it's called a capital loss when you sell an asset for less than the purchase price. Capital gains allow a company to reinvest back into their business or to finance another investment. For example, a company owns a building that they purchased for $250,000. They sell the building for $400,000. Their return on investment paid out as a capital gain is $150,000.
An organization pays out dividends to its shareholders as a portion of the company's earnings. A company's board of directors decides how they distribute the dividends. For example, they can pay out dividends as cash or additional company stocks.
Areas of business that use return on investment results
Although return on investment is a financial term used for cash investments, such as stocks, bonds, and mutual funds, several business areas use the same concept. Some of these areas include:
A marketing department increases brand awareness and sales for an organization. When planning their marketing campaigns, a marketing department also analyzes the return on investment of their strategy. A company wants to know what the return is on the money they allocate to marketing and advertising. When performing their calculations, marketing departments use the amount of money spent on a particular campaign along with the sales directly related to the marketing to evaluate the campaign's effectiveness. This data provides marketing managers with critical information to improve their strategies, assess market conditions, and analyze areas of opportunity.
Training and development
Human resources and training of employees use return on investment to decide on new development strategies. This is common when an organization seeks a new training platform or offers internal employee development programs. For example, suppose a company is thinking about changing their in-person new staff orientation to a self-directed virtual platform.
There are costs associated with the software and the development and recording of the materials for the program. Before deciding, the department would consider the return on investment considering the time, energy, and cost savings from moving into a different orientation strategy. Return on investment helps the department to analyze the decision based on a positive or negative return.
The IT department of an organization also uses return on investment calculations to make various business decisions. For example, they can look at the return on investment for changing over to a new database server, software system, or hardware product line. They can also compare various ROIs for different scenarios to make the best decision for the company from a financial standpoint.
For example, the IT department manager may compare the return on investment for refurbishing hardware or purchasing new. The calculation allows them to consider all costs incurred with both options and make the best decision based on the return of investment.