Return on Investment (ROI) – Definition
Return on Investment refers to the return which the company generates from the investment during the period under consideration with respect to the amount of investment made by the company till the point of time i.e., it measures the efficiency of the investment of the company.
In simple words, it calculates the profitability of the company by measuring the earnings related to the amount of capital invested. Capital is a costly resource so business should invest in a project which can provide an adequate return that can accommodate the capital charge. Return On Investment (ROI) ratio is expressed as a percentage of capital employed in the business. Below given is the formula to calculate ROI with example.
How to Interpret ROI?
ROI is represented as:
- Higher the ROI of the business, the better the business is performing. EBIT represents the profit earned by the business before paying interest on debentures and taxes thereby only deduction amount which requires running the business and cost of the material sold.
- Capital Employed includes all the liability and shares capital excluding current liabilities like Share capital, Capital premium, Free reserves, Retained earnings, Debentures, Long term debt from a bank, or unsecured long term borrowing.
- EBIT of the firm is not affected by the different capital structures of the different firms because we are considering the profit before paying an amount to the debenture holder or long term fixed rate receiver.
Types of ROI
- Before Tax ROI
- After-Tax ROI (More popular)
If we take the tax component into consideration then it will become EBIT (1-Tax) / Capital Employed.
EBIT x (1-tax) is also known as net operating profit after tax (NOPAT). People use to calculate their return in an after-tax form so the net realizable profit can be calculated.
Return on Investment Examples
The following are the details for the year ended 31st Dec, 18 Brian Inc.
ROI Formula = 280000/2000000
ROI = 14℅
Squash Inc. is a conglomerate and has 4 divisions. Total capital invested in the business at the starting of this year – $ 60 million.
Similarly, we can do the calculation of the return on investment ratio for the remaining division.
You can refer to the given above excel template for the detailed calculation of return on investment ratio.
By looking at the return its appealing that firm education department is generating more revenue, but if we dig inside and check ROI and other ratios then it will be like education division is enjoying at the cost of telecom and pharmacy division by diluting their profit and overall reducing the profits for the company, thereby not utilizing the capital in the best manner.
Benefits of Return On Investment (ROI)
The business invests in a project by funding from different sources debt, equity shares so in terms of getting capital businesses need to return back the interest on debt and dividend against capital. so businesses should earn at least to pay to capital stakeholders in a timely manner.
ROI is :
- Easy to calculate and better to communicate.
- Can be applied to any investment return.
- Helpful in benchmarking and comparison purposes.
- Globally accepted formulas.
Sometimes in place of Capital employed, Invested capital is also used.
Limitations of Return On Investment (ROI)
ROI itself cannot help to decide which business is doing better in itself because every business has different aspects and financial leverage so while comparing two financial statements it should be kept in mind that both the company to some extent have some business risk. Some major limitations of ROI:
- Earning is easy to manipulate by the management resulting in higher Operating margins and higher NOI.
- The capital structure of the firm is too flexible so it’s problematic to take the actual capital employed.
- ROI does not consider the time value of money. Sometimes a small investment is earning high value but it’s taking too much time then its high value is no relevance if we calculate the present value to that future resulting amount.
High ROI doesn’t make the business profitable but we should compare the ROI with the cost of capital to get the full picture. Return on Investment Ratios should be used in conjunction with other ratios as well like internal rate of return (IRR), Net present value (NPV), discounted cash flow value (DFC), Return on Equity (ROE), Return on assets (ROA).
It depends on the outlook of the investor like if the investor is investing for a period of smaller horizon then time value has a little factor to contribute to the ROI can provide a better view but in the long run, choosing the project on the basis of ROI can even make the situation worse for the investors and stakeholders.
This has been a guide to What is Return On Investment (ROI) & its definition. Here we discuss how to Interpret ROI along with step by step example. You can learn more about finance from the following articles –