Helping You Understand The Concept Of What Return On Investment Is!
The financial term ‘return on investment’ (ROI) is a percentage indicating the profits or losses from money invested and is often referred to as ‘rate of return‘.
Nearly all companies will use a variation of ROI to determine the value of potential investment opportunities. If the percentage is positive then the investment will make money; if the percentage if negative then the investment will lose money. The ROI equation is equally valuable in choosing between a number of investments; the investment with the highest ROI will make the most money. When determining how to allocate capital the investment with the highest ROI should be chosen first, with remaining capital going to the second highest, and then to the third highest and so on.
Often times ROI calculations are based on estimated figures so it is nearly impossible to know the exact future value of the investment and the gains from the investment.
ROI calculations are not only applied to financial investments such as bonds, equipment or stocks. ROI also applies to marketing campaigns over a certain period of time that will eventually work to improve customer awareness and increase sales. This can be calculated over a specific investment project as well as calculated as an average over a whole quarter or year
As you can see, the ROI metric is flexible and relatively simple to use. It can be adjusted to any situation and is vital component in any investment or marketing review.
Why is ROI as a Percentage a Vital Component?
It is not possible to compare the performance of investments in monetary values simply because not all investments use the same financial inputs. It would be incorrect to compare the profit of a $100 investment to that of a $10 000 investment unless you calculate the profits in proportion to the investment. ROI is a great way to compare the two investments as the calculation is based on a percentage.
In this case a $30 return on the smaller investment ($100) could be better than an $700 profit made on the bigger investment ($10,000). In order not to try and compare this $30 and $700 and make correct investment decisions, a formula was written to measure investment profitability as opposed to the size of an investment.
Calculating ROI
When calculating ROI there are many factors that should be taken into consideration. These include:
- Sales over the period
- Latent sales
- Value
- Average rate of return of an investment project
Note: Latent sales can sometimes make up a significant part of the return on a item that has a long sales cycle like a big ticket item.
To calculate straight return on investment, the profits made from the investment is divided by the cost of the investment, according to the following formula:
ROI = [Gain from Investment - Cost of Investment] / [Cost of Investment]
OR
ROI = [Profit] / [Cost of Investment]
In the case of the $30 and the $700 return mentioned above, the calculations would be the following:
ROI Investment #1 = (130-100)/100 = 30%
ROI Investment #2 = (10700 – 10000)/10000 = 7%
Many prefer to calculate the rate of return that takes short term and long term sales cycle into consideration. The overall rate of investment is calculated based on a timeline of costs and returns and accounts for the time value of money ($100 today is worth more than $100 one year from now).
Investments may have many hidden costs that should be included when you calculate ROI. These can include:
- Maintenance costs
- Taxes
- Research costs
- Time that the investment will demand.
Because very few investments are straightforward and often include additional payments or lump sum pay-outs, many companies now offer spreadsheet software that make ROI calculations simple and more accurate. This software comes highly recommended as complicated ROI calculations may be very time consuming and errors can potentially lead to poor investment decisions.
What ROI calculations are used for?
When companies draw up budgets of how they will apply capital during a specific period, they rely heavily on return on investment calculations to identify the most profitable investment projects.
This study is vital in maximising profits to be made from investments. Investors look intensively at inflation estimations and the risk of an investment when calculating the ROI at which they are willing to invest at. More recently the rate of investment is not only being used for traditional capital investment calculations but also when purchasing assets or programs like marketing or recruitment software.