What is ROI (Return on Investment), one of the most used financial balance sheet indicators? Here is the meaning, how to calculate it, the formula, and how to best use the ROI index.
What is ROI? ROI (Return on Investment, is an important financial indicator for evaluating the profitability of an investment. Calculating the ROI allows us to understand whether an investment has generated a sufficient profit compared to the capital invested.
The ROI index is part of the category of financial statement indicators and its formula is a useful tool for evaluating the profitability of a company or investment. For this reason, ROI is widely used in corporate finance and is a tool any professional should master.
The ROI calculation is often used to evaluate a financial investment but also to evaluate the effectiveness of a marketing operation. To understand what ROI is, it is necessary to study its calculation and formula in order to delve deeper into the possible uses for evaluating a company’s shares.
What is ROI?
The ROI, Return on Investment, is one of the most used balance sheet indicators in the financial world thanks to its versatility and ease of use.
ROI is a percentage ratio that shows the return yielded from an investment compared to the capital invested. It indicates the efficiency and profitability of an investment and is widely used in the financial world to evaluate the performance of a company.
It is one of the financial statement indicators, such as ROS (Return on Sales), ROE (Return on Equity), and ROA (Return on Asset) used by analysts or potential investors to understand profitability and the profitability of the company studied.
Let’s see how the ROI allows us to evaluate the efficiency of an investment or to compare the efficiency of different investments with each other. Moreover, both owners and investors view this indicator as having a complete vision of the company, let’s see why.
ROI index calculation formula
In particular, the ROI is useful for understanding the profitability of corporate investments given that it relates the operating result to the operating net invested capital.
The general ROI formula is the following:
ROI = Operating Profit / Net Invested Capital
Where the Net Operating Invested Capital is:
Total Net Assets - Extraordinary investments
The ROI can also be calculated through the use of other indicators, for example by multiplying the ROS by the ROT (turnover rate of invested capital) or by multiplying the Turnover (ratio between sales and invested capital) for ROS.
According to the DuPont model, a company’s ROI is calculated by multiplying the return on sales by the asset turnover (i.e. the profitability of the company’s resources to produce income):
ROI = Return on sales X Asset turnover
The formula to calculate return on sales is as follows:
Return on Sales = Profit / Net Sales
The formula to calculate asset turnover is as follows:
Asset turnover = Net sales / Total capital
ROI calculation example
We assume that a company has the following data for the accounting period in question.
- Net revenues 45.5 million dollars
- Total capital 20.3 million dollars
- Profit (before interest) 2.8 million dollars
To calculate ROI, we first need to determine the company’s return on sales. To do this, we must first divide the profit by the net sales, then multiply the result by 100 to get the percentage.
Return on Sales = (Profit / Net Sales) X 100
For the company, for example, the result is a return on sales of 6.15%.
Now let’s calculate the asset turnover. To do this, we divide net sales by total capital and get 2.24.
Now we multiply the profit on sales by the asset turnover and obtain an ROI of 13.8% for the accounting period under consideration.
ROI = 6.5 X 2.24 = 13.8%
How to calculate ROI on a single investment
If you do not want to determine the asset turnover of an entire company but the profitability of a single investment or that of a specific company division, here are the instructions on how to do the calculation.
You need to divide the profit share of the investment or business division by the respective capital expenditure and multiply the result by 100.
ROI = Profit share of the investment / Investment X 100
This type of calculation is used, for example, in online marketing to evaluate the success of advertising costs compared to the profit they generate. In this context, we are specifically talking about return on marketing investment (ROMI).
ROI: usage and functionality
ROI is generally used by business owners or majority shareholders of a company rather than by potential investors or traders. This is because those who are preparing to purchase a package of shares will prefer to look at the ROE which gives a greater suggestion of the profit generated for shareholders. However, ROI is always taken into consideration given the ease of use of the indicator.
In fact, the ROI of two different companies can be compared, thus choosing the one that has the highest value of this indicator. This is because a high ROI, above the average interest rate on debt, indicates that it would be profitable for the company to borrow money to invest in the expansion of production factors.
Conversely, a low ROI or lower than the cost of the money borrowed means that the company analyzed is incapable of generating profits from investments and if it borrowed money to carry out business expansions it would risk eroding the remuneration of third parties (ROE ) by increasing leverage.
This is why ROI is generally also compared to ROE, since this way it is possible to have a better picture of the company both in terms of profit performance and in terms of new business expansions.
From ROI to SROI
In recent years, precisely at the beginning of 2000, some investors have modified the classic ROI approach by developing some updates such as SROI, Social Return on Investment, which takes into account the social impact of corporate projects. With SROI, such impacts would be included in planning decisions regarding the allocation of capital and other resources.
The limits of ROI
Although ROI is a useful indicator for evaluating the profitability of an investment, it has some limitations. For example, it does not take into account the time period in which the profit was generated, nor does it consider any fluctuations in interest rates or market conditions.
Furthermore, ROI does not take into account other important factors such as the risk of the investment or the impact of extraordinary events on the company. Therefore, it is advisable to use ROI in combination with other financial indicators to comprehensively evaluate the performance of an investment.
Original article published on Money.it Italy 2023-11-15 17:57:40. Original title: Cos’è il ROI? Calcolo e formula
