WHAT IS RETURN ON INVESTMENT?
Return on investment also known as ROI for short can be said to be the additional cash or fund which comes from an asset on which money was originally invested in. It is the benefit gotten by an investor as a reward for the purchase of an asset or security which is solely based on profit making. It measures the level of profit gotten from an investment in relation to the amount spent on acquiring the investment.
HOW IS ROI CALCULATED?
ROI is calculated by subtracting the cost of investment from the gain gotten from investment and then dividing through by the cost of investment. In simple terms, return on investment is calculated by subtracting the expenses from the profit and dividing by the total expenses. Return on investment is usually expressed as a percentage and as such the calculation should be multiplied by 100 to give the percentage value. The formula for finding return on investment is:
ROI = net income ÷Total investment
Net income = gross profit – expenses
BENEFITS OF RETURN ON INVESTMENT
Return on investment is beneficial to the investor and management in so many ways. It helps to give the management a basis for clearing their performance in different areas. It is beneficial for the purpose of evaluating a proposed investment in new machineries by dividing the profit increase attributed to the new equipment by the capital invested in it. Return on investment formula is easy to use and is applicable to any form of investing. Accurate calculations of return on investment can serve as a yardstick for measuring effectiveness and efficiency in business management. To calculate ROI, a new accounting measurement is not required rather it is still based on the existing financial accounting measurement. It helps in easy comparison between different varieties of investments. ROI relates net income to investments made in a division thereby providing a better measure of divisional profitability. Finally, the use of ROI ensures that assets, machines, equipments, etc are purchased only when they are absolutely necessary and can give maximum returns that are profitable in nature.
There are different models for calculating return on investments. One should make sure to test and understand a model and its limitations before using it or better still use multiple models to be able to gain a more and complete understanding of the financial opportunity surrounding him. ROI is not a totally complete tool for evaluating opportunities; the investor should bear in mind other factors that might affect the predictions like risks. All in all the return on investment calculation is necessary and important in running or managing an investment because it helps to keep the investor abreast with progress made in investment as well as the amount of profit or loss made from an investment.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.