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Understanding Return on Investment
The financial well being of a company is usually assessed by computing the liquidity, the turnover, the profitability, and the debt ratios. Return on Investment (ROI) is a ratio that helps to measure the profitability of a company. It indicates the degree of effectiveness with which a firm uses its capital to generate profits. This ratio is preferred to other measures of profitability on account of the ease of computing and interpreting the results. Investments that have a higher ROI (return on investment) are chosen as an alternative to those yielding lower returns. It goes without saying that investment opportunities with negative or zero ROI should not be undertaken.
Calculating Return on Investment. The formula for calculating Return on Investment is as follows:
Return on Investment = Gain from Investment / Cost of Investment
The above formula is versatile and can be suitably modified to suit one's purpose. For instance, a company may talk of Return on Invested Capital (ROIC), Return on Assets (ROA), or Return on Equity (ROE), since each of these measures helps to gauge the profitability of the investment. A marketing manager, on the other hand, may talk of ROI in terms of the revenue generated by a product, and the expenses incurred on the marketing campaign for promoting the sale of the product. A person into stock investing may compute the return on investment by considering the dividends and the capital gains as income or gain from investment, and the purchase price of the stocks as cost of investment.
Modifying the Return on Investment Formula
It's evident that ROI is a very flexible formula that can be used by suitably modifying the gain from investment and the cost of investment. The following examples can be used to elaborate on this point.
Calculating Return on Equity: Return on Equity (ROE) is calculated by dividing the net profit after taxes (net income) by the shareholder's equity. Net Income is calculated by considering the total revenue generated by the business, and making a number of additions and deletions to it. The total revenue is computed by considering revenue per unit of sales * total sales. The cost of goods sold is then subtracted from total revenue to arrive at gross profit. The gross profit is then adjusted by subtracting non–cash operating expenses, like depreciation and amortization, and operating expenses, like wages, salaries, interest and rent. Again, operating and non-operating income are added to the gross profit in order to arrive at net profit before tax. The taxes are then deducted from this figure to arrive at Net Profit After Taxes. Shareholder's equity refers to both common and preferred equity. Thus, Return on Equity can be calculated as:
Return on Equity = Net Income / Shareholder's Equity
Calculating Return on Invested Capital: Return on Invested Capital (ROIC) can be calculated by dividing the retained earnings by the the total capital. Retained earnings are computed by subtracting the dividend that is paid to the shareholders from the Net Income. Total Capital includes preferred stock, common stock, and long term debt. The formula for ROIC is as follows:
Return on Invested Capital = (Net Income – Dividends) / Total Capital
Return on Equity (ROE) can be used by a shareholder to assess the ability of the management to create wealth using the shareholder's money, while Return on Invested Capital (ROIC) can be used to assess the management's efficiency regarding allocating the entire capital that is under its control, to profitable investments. Hence, the cost of investment and the gain from investment needs to be understood before trying to interpret return on investment calculations. A number of online resources offer return on investment calculators that can be used to figure out the profitability of the investment.
Hopefully, the readers now have some insight on how to calculate return on investment. The versatility of the return on investment formula is thus evident from the above usage wherein the formula is modified in order to suit the needs of the shareholders and the management. Hence, we can say that calculating return on investment yields a performance measure that is used to evaluate the relative efficiency of an investment.