RETURN ON INVESTMENT
Return on Investment (ROI) is a performance measure that provides information about the efficiency of a company or an investment. In practice, the ROI enjoys a high significance among investors. Among other things, external addresses use this calculation method to verify the creditworthiness of a business or to assess how profitable an investment is. The return on investment is often also referred to as capital profitability or rate of profit.
When calculating the return on investment, the following two methods are usual:
On one hand, the ROI results from multiplicating two financial ratios - the return on sales and the capital turnover:
Return on Investment = Return on Sales x Capital Turnover
The return on sales is calculated by dividing the profit by the net sales and explains the percentage of profit from the turnover of the company. The capital turnover, however, shows the relationship between the sales revenue and the total capital employed by a company and thus provides information about the speed of a company’s selling process.
Another common practice when calculating the ROI is dividing the profit by the total capital:
Return on Investment = profit / total capital
Both components of the calculation can be read off the balance sheet at the end of a business period. The formula used to calculate the ROI is therefore similar to the calculation method for return on equity and return on assets. However, this is not surprising, since these figures represent special characteristics of the return on investment.
IMPORTANCE AND INTERPRETATION
The ROI is of particular importance in the business and finance industry. For example, in the profitability analysis, there is a comprehensive system of financial indicators, which allow valid statements about the rate of return.
The KPI system of the American group Du-Pont, which is still used today for balance sheet analysis and group management, has acquired an excellent reputation in this field.
The return of investment is a relative measure that allows comparison of unequal companies or investments. As shown above, the measure shows the relationship between the profit and the capital required to achieve it, allowing an independent comparison of different businesses, units or investments.
With the reported relative ratio, the ROI expresses what proportion of an investment will return as a profit within one period.
This not only determines how long it takes for an investment to pay for itself, but it is suitable for checking your own profit targets as part of corporate planning.
In business and finance practice, ROI is not only applied to business planning (e.g., financial planning) but also to the retrospective analysis. The way of looking at the key figure is fundamentally past-oriented. However, the use of planned figures and trend lines does not just limit the informative value to a brief look at the past.
DISADVANTAGES OF INTERPRETATION
The ROI is able to represent a complex issue - such as a return on investment - in a simple and concise way. This is done by condensing a lot of information from one period. Of course, pieces of information get lost during this process. For example, the ROI can be corrupted by money that has gone into off-balance sheet assets, as this information is not included in the calculation. In addition, due to its calculation system, the ROI can not include special forms of financing. These forms include effects from leasing or sale-and-lease-back financing.
The purely monetary view also does not indicate how risky an investment was or is. The ROI should therefore never be used solely for decision-making, but rather to support a decision in the investment process. With regard to the risk of a plant, it would be advantageous, for example, to consider different scenarios in addition to the ROI. In a negative scenario, some investments may lead to a total loss of the invested capital, while in the worst case no profitability is to be expected for the investment.
Scientifically, is also disputed which target value of the ROI is to be classified as good. Basically, any positive ROI is beneficial here. However, in practice, the ROI valuation depends on each goal of the manager or operation.
REQUIREMENTS FOR APPLYING THE ROI TO INDIVIDUAL INVESTMENTS
In order for the ROI to be used to assess a single investment, additional accounting information is required. Instead of the corporate profit, the profit share, which is responsible for the investment, should be included in the formula. For this purpose, larger companies often need a cost-breakdown, while smaller companies may still know their individual profits. If the investment does not directly generate profit (return), it is possible to use the cost savings instead of the profit. This makes sense, for example, if a real estate company wants to assess how profitable an energetic measure is.
In addition, it is not the entire capital of the company that should be used, but only the capital used for the investment:
ROI = profit share or saving/investment costs
The definition of overheads can be difficult and may require the use of billing keys to allocate overhead cost.