Return on Investment or ROI, is a measure of relative gain or loss on an investment. Return on investment is an important factor in making investment decisions. ROI is expressed in percentage and helps one decide whether they should put their money in a certain investment or skip it altogether.
This post talks about the importance of return on investment, ROI formula and how to calculate return on investment.
How to Calculate Return on Investment?
Return on investment (ROI) is a percentage that assess the profitability and efficiency of an investment. The main objective of calculating return on an investment is to directly measure the profit you’ll gain compared to the investment’s cost.
ROI Formula
That said, here’s how you can do ROI calculation:
Return on Investment = (Net Profit or Net Loss / Cost of the investment) x 100
(Net Profit/Loss = Current Investment Value – Cost of Investment)
- Current Investment Value: Value of the stock on a particular date, or proceeds received from the sale of an investment
- Cost of Investment: Amount invested at the beginning
Let’s understand how to calculate Return on Investment with the following example:
You purchase a land for Rs 50 lakhs and later sell it for Rs 60 lakhs. The return on investment would be:
ROI = (Net Profit/Cost of land) x 100
= {(Selling Price of land – Purchase Price of land)/Purchase Price of land} x 100
= {(Rs 60 lakhs – Rs 50 lakhs)/Rs50 lakhs} x100
= Rs 10 lakhs/Rs 50 lakhs x 100
= 20%
The total return on investment you made is 20% which is a positive percentage.
You can also calculate projected ROI to decide if a certain project will give you expected returns in future. This is done by ascertaining an expected return on a certain project. The higher the ROI, the better will be your investment, in terms of financial gains.
Return on Investment: Importance
If you are investing in a business, expanding your operations or simply making investments in financial assets, calculating ROI is of utmost importance.
Return on Investment facilitates comparison between different investment options and business units in respect of profitability and asset utilization. It can be used for inter-firm comparisons, given that the organizations belong to the same industry and are of the same size.
In this regard, Return on Investment is ideal as it can be easily compared with the related cost of capital to determine the selection of investment opportunities.
Return on Investment: Minus Points
Different Accounting Methods
Different companies may use different accounting methods to calculate the return on investment.
Return on Investment is recommended when companies use similar accounting practices and methods when we are talking about stock valuation, fixed asset valuation, apportionment of overheads, development expenditure and such.
Undermines Value of Time
The one major limitation of Return on Investment is that it does not consider the time value of money.
For instance, let’s say you invest in stocks that offer a Return on Investment of 50%. Some investors might consider it a highly profitable investment, but it is not, if it takes 10 years to give this return.
Return on Investment: FAQs
A negative Return on Investment indicates a loss.
Return on Investment considers the money invested in the company and the return you receive on that investment, according to the net profit. As for profit, it analyses the performance of the business.
Use this ROI formula to calculate return on investment:
Return on Investment= (Net Profit or Net Loss / Cost of the investment) x 100
No. You must think about the time factor while taking into account inflation as these greatly affect the returns.
While ROI indicates total growth during the investment tenure or holding period, IRR indicates the annual growth rate.
Also Read: Post Office Savings Schemes On Investment Simplified
