The return on investment or return on investment (ROI for its acronym in English: Return On Investment ) is a financial index or indicator that measures the profitability of an investment; that is, the relationship that exists between the profits or gains obtained or expected to be obtained, and the investment.
Knowing the ROI of an investment allows us to know its profitability and thus, for example, know if the investment is profitable, how much it offers us for our money, and how attractive it is compared to other investment alternatives.
ROI analysis ultimately allows us to know whether or not we should make an investment.
In this article you will find:
- What is ROI?
- What is the usefulness of ROI?
- How to calculate ROI?
- Examples of how to calculate ROI
- Endnotes
What is ROI?
The return on investment or return on investment (ROI for its acronym in English: Return On Investment ) is a financial index or indicator that measures the profitability of an investment; that is, the relationship that exists between the profits or gains obtained or expected to be obtained, and the investment.
Being specific, ROI measures what percentage of our investment (capital) we have recovered or earned (or are going to recover or win); for example, an ROI of 10% means that the investment we have made (or are going to make) has allowed us (or will allow us) to recover or earn 10% of it.
What is the usefulness of ROI?
Knowing the ROI of an investment allows us to know its profitability and thus, for example, know if the investment is profitable, how much it offers us for our money, and how attractive it is compared to other investment alternatives.
We can use ROI to calculate the profitability that an investment has had ; for example, the profitability that a company has had in the period, that has generated a product, or that has allowed us to earn a financial asset.
But ROI is generally used to calculate the return that can be earned on an investment ; for example, the profitability that can be gained with an investment project such as the creation of a new company or the launch of a new product, since by allowing us to know if an investment is profitable and how much it offers us for our money, which ROI ultimately allows us to know whether or not we should invest in it.
How to calculate ROI?
To calculate the ROI of an investment we must know the investment (capital) that has been made or will be made, and the profits, gains or benefits that have been obtained or are expected to be obtained with the investment.
In the case of a company, to know the profits that have been obtained we must go to its income statement , and to know the profits that are expected to be obtained we must go to its projected income statement.
Once we know the investment and the profits or earnings, we apply the ROI formula , which is as follows:
| ROI = (Profit or Profit / Investment) x 100 |
Where :
- ROI : rate of return on investment.
- Profit or Gain : profits, gains or benefits obtained or expected to be obtained from the investment during a certain period of time.
- Investment : capital that has been invested or will be invested.
The result obtained by applying the ROI formula will be in percentages and indicates what percentage of the investment made or to be made has been recovered or earned, or will be recovered or earned.
Possible results :
- An index greater than 0 means that the investment is profitable.
- An index equal to or less than 0 means that the investment is not profitable.
Examples of how to calculate ROI
Let’s see below some examples of how to calculate and interpret ROI:
Example 1
A company whose total investment was US $ 4,000, obtained net profits of US $ 1,000 at the end of the period. What is its ROI?
Applying the ROI formula:
| ROI = (Profit or Profit / Investment) x 100 |
ROI = (1000/4000) x 100
ROI = 25%
It gives us a ROI of 25% with which we can affirm that the company (or the investment made in the company) in profitable, and obtained a return of 25%.
Comments :
- As the ROI is greater than 0, the company is profitable (the higher the ROI of a company, the more efficient it is when using its capital to generate profits).
- If an ROI equal to or less than 0 had been obtained, the company would not be profitable (investors would have lost money).
Example # 2
An investment project has an investment of US $ 5,000, and a forecast of earnings for a specified period of time of US $ 800. What is your ROI?
Applying the ROI formula:
| ROI = (Profit or Profit / Investment) x 100 |
ROI = (800/5000) x 100
ROI = 16%
It gives us a ROI of 16% with which we can affirm that the project is profitable and offers us a profitability of 16%.
Comments :
- As the ROI is greater than 0, the project is profitable (the higher the ROI of a project, the greater percentage of the capital will be recovered when invested in it) and, therefore, it is feasible or feasible.
- If an ROI equal to or less than 0 had been obtained, the project would not be profitable and, therefore, it would not be feasible or feasible (since in case of leaving, the money invested would be lost), and we should look for other projects in which to invest.
- If in addition to this project, we had other project alternatives with an ROI of 20%, 25% and 10%, in theory we should choose the project that has the highest ROI since it is the one that offers us the highest return on our investment.
Endnotes
Due mainly to its simplicity, ROI is one of the main financial tools used when evaluating an investment project ; however, we must bear in mind that this indicator does not take into account the value of money over time; that is, the fact that a certain amount of money today will not have the same value in the future.
So when evaluating an investment project, especially if it is a medium or long-term project, such as creating a new business or launching a new product line, it is recommended to use it together with other financial tools, such as the NPV and the IRR , and the cost-benefit ratio .
