What is in this article?
- What Is Return on Investment (ROI)?
- How Is ROI Calculated?
- An ROI Example
- Why ROI Matters
- The Limitations of ROI
- Conclusion
What Is Return on Investment (ROI)?
Return on investment (ROI) is a financial concept used to measure the return of an investment. ROI shows how much profit an investment has produced relative to its cost. It helps a business determine the value of a particular investment and is generally used to guide investment decisions.
ROI helps a business determine the value of a particular investment and is generally used to guide investment decisions.
How Is ROI Calculated?
Calculating ROI is quite simple. First you need to find the total return of the investment. That is usually expressed as the total income obtained from sales, interest income or other income sources.
Then you need to compare that return with the cost of the investment. The cost of the investment is usually expressed as its initial cost, but it can also include additional spend made to sustain the investment.
ROI is calculated with the following formula:
ROI = (Net Income / Investment Cost) x 100
This formula gives ROI as a percentage, which lets you compare the return of an investment easily.
An ROI Example
For example, a business makes an investment of 10,000 dollars and obtains an income of 12,000 dollars from that investment. In that case the net income will be 2,000 dollars (12,000 – 10,000).
ROI in this case is calculated as follows:
ROI = (2,000 / 10,000) x 100 = 20%
That means the investment delivered a 20% return relative to its cost.
Why ROI Matters
ROI helps a business determine the value of a particular investment. A high ROI shows the investment delivered a high return relative to its cost, which generally indicates the investment was successful.
ROI can also be used to compare the returns of different investments. That can help a business determine which investments are the most profitable.
The Limitations of ROI
Although ROI is simple to calculate, the measure has some limitations. First, ROI measures an investment's return but does not show over what period that return was obtained. That can make it harder to determine an investment's real value, because an investment's return usually changes over time.
ROI also does not take an investment's potential risks into account. A high ROI shows an investment delivered a high return, but it does not show that the investment may also carry high risk.
Finally, ROI measures an investment's cost and return but does not take its other potential benefits into account. An investment might increase a business's brand awareness or improve customer loyalty, for example, but those benefits are generally ignored in the ROI calculation.
Conclusion
ROI is an important financial concept used to measure an investment's return. But to determine an investment's real value it is important for a business to understand ROI's limitations and to evaluate the measure alongside other important factors.
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