The term Return on Investment is one that is very common, especially when attempting to determine the benefit gotten from a particular investment. It is considered as a means of measuring what you earn compared to what you put in. It is necessary to know how to calculate return on investment as well as its importance and the challenges that usually arise when trying to determine ROI. However, before covering that aspect, it is first of all essential to know the meaning of Return on Investment (ROI) as well as what it entails.
What is Return on Investment?
Return on investment, or rather ROI for short, is a performance measure that is used to assess the efficiency of an investment or compare the efficiency of various investments. Return on investment (ROI) is aimed at directly measuring the number of returns on a certain investment relative to the cost of the investment.
ROI can also be defined as a financial metric that is generally used to determine the probability of earning a return from an investment. It is usually a ratio that analyzes the loss or gains from an investment that is relative to its cost. It is as efficient as comparing returns from various investments to determine the potential return from a stand-alone or single investment.
When it comes to business analysis, return on investment as well as other cash flow measures like net present value (NPV) and rate of return (IRR) are key metrics that are used to rank and determine the attractiveness of a number of various investment alternatives. Return on investment is usually expressed as a percentage even though it is a ratio.
How To Calculate Return On Investment (ROI)
To calculate return on investment, you simply divide the return or benefit of an investment by the cost of the investment. In this case, the result is usually expressed as a ratio or percentage. The formula for calculating the return of investment is as follows:
Return of Investment (ROI) = Current Value of Investment – Cost of Investment/Cost of Investment.
In this case, the “Current value of Investment” is the proceeds gotten from the selling of the investment of interest. As the return on investment is measured as a percentage, it can easily be compared with returns or gains from other investments, which allows one to measure various investments against one another.
Understanding Return On Investment (ROI)
Return on Investment is a popular metric, mainly due to its simplicity and versatility. Typically, ROI can serve as a rudimentary gauge or determiner of an investment’s profitability. It could be the return on investment on a stock investment, the return on investment generated in a real estate transaction, or the return on investment a company expects of expanding a factory.
Calculating ROI is not difficult or complicated, plus it is easy to interpret for its vast range of applications. If the ROI of an investment is not positive, then it is most likely worthwhile; however, if other opportunities with an increased ROISs are available, these signals can enable investors to eliminate or choose the best options. Investors should learn to avoid negative ROI’s which best suggest a net loss.
How Return On Investment (ROI) Works
To cite a practical example, if you spend 1000 dollars every month for a pay per click advertising and from the campaign earn 2000 dollars in revenue, you divide the profits by the cost in other to determine the return on investment, multiply by 100 to determine the percentage. Basically, for every dollar spent on PPC ads, you earn a dollar in profit. in a situation where you spend 1000 dollars every month on an ad campaign and instead earned 1200 dollars in sales, you earn a yield of 200 dollars, and your return on investment will be 2000 dollars divided by 1000 dollars, which should give you 20% or 0.2. in context, you earn 20 cents in profit for every dollar spent on the pay per click campaign
It is essential for you to consider the return on investments for every expense you have. Like, how much impact will a new faster computer have on your business? Questions like this are important for determining which investment is most suitable.
Benefits Of Using The Return On Investment(ROI) Formula
Using the return-on-investment ratio provides numerous benefits an advantage that every analyst should know about, and they include;
*It is easy and simple to calculate
As earlier implied, the ROI metric is constantly being used due to the fact that it is so easy to calculate. It requires only two figures, which are the cost and benefit. A return can mean various things to different people, which is why the formula is used, as there is no single definition of return.
*It is universally understood
The concept of return on investment is one that is generally understood, so it’s a guarantee that if the metric ever comes up in a conversation, then people are sure to know what you are talking about.
Limitations Of The Return On Investment (ROI) Formula
Though the formula is often beneficial, it is necessary to understand that there are some limitations to the return on investment formula, and it is very crucial to know what they are. Notable among its limitations include;
*The Return on Investment formula disregards the factor of time
A high ROI number does not always necessarily mean a better investment option. To sight an example, let’s assume that two investments have a similar ROI of 70%. However, the first investment will be finished in two years, while the second investment will require six years to yield the same result. Similar ROI for both investments does not allow one to see the bigger picture, but when the factor of time was included, it allows the investor to determine the better option.
The Return on Investment formula is prone to manipulation
A return on investment calculation can vary between two people based on the ROI formula been used in the calculation. A sales manager can apply the property estimation while not considering extra expenses like sales fees, legal costs, taxes on property, and maintenance. This is why an investor needs to consider the true ROI, which takes into account all possible costs which can arise when each investment rises in value.
Irrespective of the limitations of ROI, it remains a major metric used by business analysts to rank and evaluate investment alternatives. There is no denying that it still one of the most intuitive and simplest means of determining the profitability of an investment.