Calculating Return on Investment (ROI)

Return on Investment or ROI is a performance that is measured to evaluate the profit that can be generated from an investment or it can be used to compare the profit generated by different investments. When you are going to calculate the rate of investment, the benefit that you get from an investment is divided by the cost at which you have done that investment.

This is the common information by which you can get the information on how well an investment has performed. It is usually expressed in the form of a percentage and is calculated by keeping the net profit that the investment gives to the investor upon the initial cost at which the investment was done. You can compare different investments by this rate of investment method and rank the investment in different projects. The rate of investment does not take into consideration the passage of time or tenure of the investment you made.

In this article, you are going to get the details of the rate of investment. How it is done, what is its meaning, what are the benefits of the rate of investment calculation,  what does the rate of investment ratio mean, how is the rate of investment beneficial, what we understand by a good rate of investment and other such information that will help you to get a brief knowledge of another topic. Now besides this, you will also find the Frequently Asked questions. These questions will enable you to increase your ability to understand the topic and clear all your queries. Now let's have a look at this article that provides you with the much-needed information.

What Do You Mean by ROI?

When a business desires to measure the efficiency of its investments, it uses a financial calculator known as return on investment. ROI is a parameter used to evaluate the profit that the investor can receive concerning their investment cost. 

Return on cost or return on investment helps you to compare different investments you make so that you can come up with the best investment option. If you get a high rate of investment that means the investment is favourable so it is beneficial to invest the money while the low one indicates that this investment is not worth the investment you can go for some other one.

A firm measures its productivity or compares its returns through the ROI. It allows understanding both its frequency of gains and the amounts on a specific investment. It is an essential factor that helps to understand the profitability of an investment.  Basically, this rate of investment plays a major role in the investment and productivity of an individual or firm. 

What is the ROI Formula?

A business can measure efficiency through the ROI calculation formula. Although there are several formulas to calculate ROI, the two most common methods are listed below.

The First Method is,

\[ROI = \frac {\text{Net Return on Investment (Benefits)}}{\text{Cost of Investment}} \times \] 100%

Where,

The net return is the amount that a firm receives from its investments. The costs are those expenses that a business incurs during operation during a financial year.

Another formula being,

\[ROI = \frac{(\text{Final Value of Investment – Initial Value of Investment})}{\text{Cost of Investment}} \times \]100%

Where,

A value of an investment is the amount a business puts into its daily operations during a fiscal year. The result that you will get after this will help you to know whether the decisions of investment in the particular area for the whole year will turn out to be beneficial or not.

How is ROI Calculated?

The calculation of ROI is pretty simple and easy to interpret. One can quickly ascertain profits or benefits if they know how to calculate return on investment.

Business uses this metric to measure productivity or compare its profits. It is known that one can calculate ROI through two common formulas. One of the methods has net returns in the numerator as ROI can also be negative at times instead of positive.

A positive ROI means that the total returns are more than total cost, whereas negative ROI implies that the costs are more than its returns. A positive ROI indicates that investment is profitable for a business.

For understanding ROI, both the net returns and the cost of investments should be taken into consideration. The returns are always expressed as a percentage, and by using the ROI formula, one can separate low-value investments from high-value investments.

When an ROI turns positive or negative, it becomes easier for an investor to ascertain the performance of the investments. Through this financial tool, high-level management can take a fundamental decision before investing.

For interpreting the functioning of financial tool better, some return on investment examples are sited below:

Suppose, the cost of implementing a program amounts to Rs.30,000 and the savings accumulated in the process is Rs.50,000. The ROI can be ascertained as:

ROI = Rs.(50,000 – 30,000)/ Rs.30,000 \[\times\] 100  = 66.67% 

It implies that for every 1 Rupee spent, its return on investment is Rs.0.6667. 

Another simple example of ROI is, the cost summary of business is Rs.20,000. It includes facilitation fees of Rs.11,000, materials costing Rs.2,000, salaries of staff amounting Rs.7,000. The total annual benefit results as Rs.60,000. 

The ROI will be calculated as:

ROI = Rs. (60,000 – 20,000)/ Rs.20,000 \[\times\] 100   = 200%

It means that for the entire expense of Rs.20,000, its percentage return will be 200%.

What is an ROI Ratio?

The ROI is also known as a return on assets ratio, and it is a profitability calculator that evaluates the prospective performance of an asset or investment. One can calculate the ratio by applying a return on investment formula. 

It can be obtained by dividing net benefits received by total costs that a business incurs during an operation cycle. It is also named as returns ratio as it allows an investor to calculate the efficiency of a firm in utilising its assets to earn revenues. These assets include stock, machinery, cash and cash equivalents, etc.

What Do You Understand by a Good ROI in Business?

When a business puts their money into various activities such as marketing, production, and staffing, they expect a specific percentage of profit or benefit in return.

Anyone spends money with a prospective of generating revenue in return.It gets ascertained through ROI. This is why it gets considered as an essential parameter for any business activity.

A good marketing return-on-investment ratio for profitable business operation is 5:1. Any ratio over 5:1 gets recognised as a profitable one. A ratio of 10:1 is assumed as an exceptional one for any business operation.

The ratio largely depends on the cost structure of any firm and type of industry. For getting a good score, a business must cover its cost of production and marketing. It needs to get more returns than the cost of goods sold.

A good ROI  means the results are going to benefit and it is productive if you invest money in this area and if the ROI is good the form or the individual who is making the investment is on the favourable side only.

How is ROI Beneficial for a Business?

In day to day functioning of a business, ROI plays a vital role. It has wide applications due to its numerous benefits, such as:

It assists all business heads, and other top management officials to understand the proper allocation of resources.

ROI guides all investors to take essential decisions by comparing the high-value and low-value investments. 

It also helps in exploring and evaluating the potential gains from different opportunities.

It also guides an organisation in calculating its costs and understanding the possible threats of the market.

What are the Uses of ROI?

There are multiple uses of ROI in every aspect of an organisation. Some of them are listed below as:

It is an essential financial calculator useful for determining the value of returns of the past and the present. 

The ROI is a simple ratio which has a universal application to evaluate the potential of profits.

To get a more in-depth insight on the return on investment meaning, you can go through the study materials available on our website. You can also install Vedantu’s app in any smart device to take your learning with you.