Few Things You Must Know about Return on Investment (ROI)
Return on investment (ROI) - the most common profitability ratio is a measure of the profit or loss generated on an investment against the amount of money invested.
ROI estimated over a specific time period is the summation of its capital appreciation and any benefit/ income produced divided by the actual investment amount. When it involves composite calculation it is called as a total return.
How to Calculate ROI?
ROI evaluates the performance of a business or the efficiency of an investment or compares the efficiencies of different investments by dividing net profit (benefit or return) of an investment by net worth (cost of the investment). The ROI is generally expressed as a percentage or a ratio.
The general formula for calculating ROI is:
ROI = (Net Profit / Cost of Investment) x 100
The ROI calculation is actually pliable and can be calculated for different uses.
For example, if you are an investor, you may use it to calculate a return on a stock as:
ROI = (Net profit from the investment after selling the shares/ Cost of investment or amount invested in stocks) x 100.
A more precise picture of the total ROI can be obtained by deducting taxes and fees.
On the other hand, if you are a company you may use the calculation on different prospective investments to calculate the investment made by your company. But the calculation is more complex in this case with more inputs. To find out the net profit of an investment your company needs to track exactly how much amount went into the project and the time spent by employees working on the project.
Also note that, while computing the Return on investment (ROI) for a mutual fund you have to consider the adjustments in the NAV (Net Asset Value) and the changes in distributions to shareholders.
Advantages of ROI
ROI lets you make a decision whether to carry on with the investment or invest more or pull out money back from the investment. Some of the pros of ROI are as follows:
- Flexible and frequently used profitability ratio.
- Useful in comparing a company's profitability, the efficiency of various investments and for making personal financial decisions.
- Helps mutual fund investors and financial professionals to swiftly analyse the prospect of an investment without the need to waste much time and money.
- Aids in exploring and measuring the potential returns on various investment opportunities.
- Gives a better measure of profitability, ensures goal congruence and is useful for comparative analysis.
- Measures the performance of the investment division and investment centre manager.
- Also Indicates other performance ingredients such as effective asset utilization, selling price strategy, marketing and promotional strategy and cost management.
- Requires only financial accounting measurements that are easily available in financial statements.
Disadvantages of ROI
If ROI is not understood properly it may lead investors to support less-attractive opportunities. Even though ROI features many benefits, it has its own pitfalls too. A few of its drawbacks are as follows:
- It is difficult to find a satisfactory definition of profit and investment which is used for ROI calculation.
- The calculation can be manipulated and hence the results may differ among users.
- ROI focuses on short-term results and profitability and ignores to focus on long-term profitability. The basic ROI calculation does not consider time. Hence clearly it is better to get a 15% return over one year than the same over two years.
- When utilizing ROI to compare investments it is vital to make use of the same inputs to get an exact comparison.
- While relating ROI of dissimilar organizations it is essential that the firms utilize comparative accounting strategies and techniques which might not always be the case.
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Return on investment (ROI) models has enhanced use and prominence as managers battle to meet investors' growing requests. We, at Fundsguru, provide everything you need to know about ROI. Choose us for an easy and effective mutual fund investing experience.